By Mark Bern, CPA CFA
General Electric (GE) is one of the world’s largest diversified companies with operating segments that include aviation, energy infrastructure, GE Capital, healthcare, home and business solutions and transportation. The company operates in more than 100 countries and derives over 50% of revenues from outside the U.S.
United Technologies (UTX) is a global diversified company with six operating segments: Pratt & Whitney (aircraft engines), Otis (elevators), Carrier (HVAC systems), Sikorsky (helicopters), Hamilton Sundstrand (aerospace and industrial products), and UTC Fire and Security (security and fire protection). The company has operations around the globe, generating nearly 60% of revenues from outside the U.S.
Both companies are cyclical in nature, but their diversification allows the companies to benefit from various trends in different industries at varying times, thus smoothing revenue and earnings to a degree. The biggest difference between the two companies is the GE Capital unit. Comparing the debt levels of the two companies is like trying to compare apples to oranges. However, the risk associated with the financial segment at GE is a differentiator. During periods of strong economic expansion GE Capital can be a huge earnings generator for GE. However, during the financial crisis following the housing bubble GE Capital became a drag on earnings and a major source of instability for the company. For that reason, GE is no longer advantaged by a high credit rating resulting in a higher cost of capital.
Pre-financial crisis, GE typically sported a P/E of 20. Now we can expect that the P/E will expand only to about 15 during times of normal economic growth. But that is not really a bad thing for long-term investors. Considering that the current P/E is only about 12.4 this leaves some room for future multiple expansion. UTX is a more conservatively run company with a strong balance sheet that will also support a P/E of about 15. Since its P/E is currently 14.9, the company seems fairly valued and assumes normal growth levels will be sustained.
UTX continues to grow its revenues from servicing contracts which are more stable. Nearly every new elevator or HVAC system that is installed leads to a long-term service contract for maintenance. Every new sale of a helicopter leads to future parts orders and some service contracts. Every new sale by UTC F&S includes a service contract. You probably get the picture. This business isn’t entirely recession proof, but it tends to increase the stability and predictability of revenue and earnings.
According to some Fed governors, the U.S. economy is now more than 50% likely to fall back into recession within the next 12 months. Also, it appears less likely now that Europe will be able to find a permanent solution for sovereign debt problems (excessive deficit spending) by its weakest members without experiencing some painful economic contraction. If one happens, the other becomes more likely, in my opinion. And the extent of collateral damage that will result from potential European defaults is difficult to measure. It is all very dependent upon just how many countries default, whether the defaults are partial and to what degree, as well as how the interdependence between member nations of the EU play out. U.S. financial institutions claim that exposure is limited and manageable, but those same executives said pretty much the same thing about the housing crisis before it took its toll on the global economy. They may be telling us the truth this time. But I would prefer to remain cautious until more of the uncertainty is resolved.
Now let’s look at some of the numbers. I’ll start with the income statement. I actually believe that over the next five years or so GE will experience slightly higher revenue growth of about 6% a year compared to about 5% for UTX. That and all assumptions are dependent upon a reasonable solution to the problems facing the EU and limited collateral damage affecting U.S. financial institutions. However, I expect that earnings growth will be much more robust at GE than UTX simply because UTX is already running at near optimum efficiency and GE has a lot of improvements underway that should provide solid growth in margins. The compounded growth rate in earnings at GE has the potential to be 50% higher than that at UTX over the next five years if management can execute on its plans.
Cash flow is growing faster at UTX than at GE, but I believe GE will make improvements in this area. UTX increased cash flow by 14.5% in 2010 while GE managed an increase of only 2.9%. I expect improvement by both companies in 2011, with greater improvements from GE in 2012 and beyond. Profit margins for the two companies are comparable at 8.4% and 8.0% for GE and UTX, respectively. Historically, GE has been able to achieve a profit margin above 10% in most years while the current level is the norm for UTX. Once again, the primary difference is GE Capital and it will continue to differentiate the two companies in the future. On the flip side, UTX has nearly always achieved a much higher return on total capital in the mid-teens while GE, currently with about a 4% return, can generally attain an average of 6.5% return on capital. GE Capital strikes again!
Then we come to return of equity, a measure of management’s efficiency in deploying leverage when compared to return on capital. Here the two companies have historically been very similar, with both realizing near 20% returns. UTX has been the leader lately, understandably since the company is running on all cylinders, posting a 20.4% return on equity in 2010 compared to 10.6% for GE. This gap should narrow as GE Capital improves operations and as record backlog orders portend future improvements across several operating segments.
Dividends have risen for 17 consecutive years at UTX while GE’s string was broken in 2008 and 2009. Again, much of the difference can be explained by the impact of GE Capital. Going forward, I expect UTX to continue to increase dividends consistently in the range of about10% a year. GE has the potential to increase its dividend by as much as 15% per year over the same period (five years) but there is also more risk of slower growth in a downturn since GE’s payout ratio has climbed back to 44% compared to 34% for UTX. In the past GE’s payout ratio was usually near 50% until earnings nose-dived during the great recession. So, I expect UTX to maintain its ration while GE’s expands.
So, which one would I chose to own and why? I am going to answer that a little differently than you might expect. For my portfolio, I would choose UTX because I am a conservative, long-term investor who likes rising dividends and shies away from risk. However, over the long term, I believe that GE will eventually provide a higher return overall. I think that the company will enjoy some expansion of its P/E ratio when financial markets stabilize and global economic growth returns to more normal levels. So, for the investor with a long time horizon and high risk tolerance, GE can be expected to provide a higher return on investment. I must caution investors, though, that I believe that the potential for collateral damage to U.S. financial institutions from the problems facing Europe are still a threat, especially to GE, in the shorter term and could continue to depress share value for as long as two more years. The best time to enter a position in these companies, especially GE, is nearer the bottom of the next cycle as the U.S. and European economies build a sustainable foundation and begin to grow more in the 3%-plus range.
My analysis is presented as a starting place to help investors fit appropriate investments into their portfolios. Please do your due diligence and chose what fits your goals and risk tolerance levels.