In this article, we're focusing on the strengths and weakness of General Electric (NYSE:GE). We're also comparing it to United Technologies (NYSE:UTX), and although the two companies are of very different sizes (GE's market cap is $262 billion, while United Tech's is $100 billion), we think that a comparison between the two stocks could be worthwhile. That's because they sit in the same GICS sector of industrials, as well as the same GICS sub-industry of industrial conglomerates. We appreciate that many investors apportion their capital based on GICS sectors and sub-industries, so we hope you find the article useful and interesting. We look forward to your comments below!
Free cash flow
There's an old saying - "Turnover is vanity, profit is sanity, and cash flow is reality". So, we're keen to find out how GE and United Tech have performed in recent years when it comes to reality: cash flow.
Looking back at the last nine years, we're surprised to see that GE's cash flow as a percentage of sales has declined somewhat. Indeed, in 2004 it stood at 15.3%, while now it is just 10.4%. Sure, it has been lower than its current level and rebounded - for example, it fell to just 8.6% in 2006, before increasing to 16.1% the following year. However, it has been 11% or lower over the last two years, which has not previously happened during the last nine years.
Of course, capex can explain why free cash flow goes up and down, but we're also surprised to see that GE's capex as a proportion of sales has not increased by a large amount over the period. For example, it was 8.6% in 2004 and now stands at 9.2%, which is higher but not by a great deal. Therefore, it appears that while GE's sales have declined from $152 billion in 2004 to $146 billion last year, its cash flow has declined to a greater extent, while capex is slightly higher than it was in 2004.
Contrast this to United Tech, where free cash flow as a percentage of sales is now 8.1%, while it was 7.8% in 2004. Furthermore, capex as a percentage of sales has increased significantly over the same period, albeit from a low base of 2.1% in 2004, with it now reaching 3.9%. All the while, sales have increased from $37 billion in 2004 to $62 billion last year. Together, these numbers show that United Tech is selling more, reinvesting a greater proportion of sales in spending on capital items for the business, but is also improving its cash flow via a higher free cash flow as a proportion of sales figure. On the other hand, GE's top line has pulled back, and its free cash flow is suffering partly from higher capex as a proportion of sales.
We're also slightly concerned to see how GE's return on invested capital (ROIC) figure has declined over the past nine years. Indeed, it was a relatively low 6.1% in 2004, but now stands at just 4.8%. As a result, it appears as though the capital that is invested in the company is not being utilized to deliver particularly strong returns. Compare these numbers with United Tech. While its ROIC has fallen slightly more over the same period (from 16.7% to 12.8%), it remains almost three times as high as GE's figure. So, as well as a declining top line and falling free cash flow as a proportion of sales, GE does not appear to offer a great return on the capital that is invested in its business - especially when compared to sub-industry peer United Tech.
Of course, the plus side for investors in GE is that the company's bottom line is going through a period of strong growth. The company is forecast to deliver extremely strong growth numbers both this year and next year, with EPS set to increase by 37.7% in 2014 and by 8.9% next year. While next year's number may sound like a disappointment when compared to this year's, for a company the size of GE, we think it's still very good going.
While its growth prospects aren't quite so strong, United Tech still has great potential. That's because it is expected to increase its bottom line by 11% in the current year and by 9.6% next year. Both companies seem to offer strong growth potential.
We're surprised to see that there's little difference in the two companies' forward P/E ratios. While GE's is slightly lower at 14.1 (versus 14.7 for United Tech), it takes into account next year's super-strong earnings forecasts for GE. After that, United Tech seems to have the better growth profile, so we think that a slightly higher P/E could be worth paying for.
In addition, United Tech has a slightly lower price-to-sales ratio than GE - 1.6 versus 1.8 for GE. This is somewhat surprising, given that GE's top line has declined over the last nine years. In other words, we'd expect a company which has seen its top line stall over a fairly long period trade at a discount to a company (United Tech) that has seen its revenue increase by two-thirds over the same time period.
Furthermore, even though its free cash flow as a proportion of (falling) sales has dropped over the last nine years (as previously mentioned), GE's price-to-free cash flow figure of 9.9 does not appear to be relatively attractive when compared to United Tech's number of 12.7. We feel that there should be a wider gap between the two companies' price-to-free cash flow ratios, and as such, we think that GE could underperform United Tech moving forward.
Although we appreciate that GE remains a core holding for many investors, we're concerned about its top line decline over the last nine years. Furthermore, free cash flow as a proportion of those declining sales has also dropped markedly during the period, with capex as a proportion of sales only increasing by a small amount. This is in contrast to United Tech's figures, which show an improvement in sales and free cash flow as a proportion of sales, while capex as a proportion of sales has also risen.
Furthermore, GE's profitability is also in long-term decline, with its ROIC now being just 4.8%, which is much lower than United Tech's equivalent number of 12.8%. Because of this, and despite strong growth expectations this year, we think that GE should trade at a sizeable discount to United Tech. The fact that it doesn't on either the P/E or price-to-sales ratios (and to not a large enough extent on the price-to-free cash flow ratio) tells us that GE may be overvalued relative to its sub-industry peer. As a result, we feel that GE could underperform United Tech moving forward, as weakening market sentiment relative to United Tech causes the shares to lag those of its sub-industry peer going forward.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.