By The Valuentum Team
Industrial bellwether General Electric (NYSE:GE) recently began its foray into 3D printing. The company paid $1.4 billion to acquire Arcam and ALM Solutions in its plan to enter the manufacturing equipment, materials, services, and software businesses of the 3D printing industry. The move seems to be a natural extension of its industrial history, and the market is young enough that GE's massive scale advantages compared to other participants can be exploited. A meaningful near-term impact is not expected from the acquisitions, but management is anticipating 3D printing to generate $1 billion in revenue by 2020.
The expansion into 3D printing allows GE to enter a fast-growing industry where it can build a competitive position, expand its design capabilities to meaningfully reduce product costs, enable a more efficient model for services cost, and perhaps most importantly leverage the significant capacity of the GE store, which already has key strengths in materials, software and product design. We have often praised Apple's (NASDAQ:AAPL) ability to create an ecosystem of apps that has found its way into the everyday life of consumers, and the GE Store has the potential to develop into a similar type of business serving multinational corporations and government entities instead of consumers. HP has parallel hopes for its business, but we like the scale that comes with GE's existing industrial businesses.
The firm's expectations for productivity in terms of cost savings is currently $3-$5+ billion, though putting a cap on savings potential at this point in time may be an exercise in futility. GE's 3D printing investments are certainly a long-term focused strategy at this point in time, and though we're not making a matter of fact prediction that the firm will hit a home run with this space, we like its potential. We're big fans of the measured exposure the company's investment in 3D printing gives our Best Ideas Newsletter portfolio.
Image source: GE presentation
General Electric's Investment Considerations
• GE is one of the largest and most diversified industrial firms in the world--with products and services ranging from aircraft engines, power generation, water processing, and household appliances. The firm continues to transform its portfolio to reduce its exposure to financial markets. The company was founded in 1892 and is headquartered in Connecticut.
• In 2016, GE is expecting organic growth of 2%-4% and core margin expansion to drive operating earnings per share to a range of $1.45-$1.55. Cash from operating activities is expected to exceed $30 billion for the first time since 2012. Our assumptions are in line with these expectations.
• GE has strong liquidity, a large backlog, and major cost programs underway to deal with anything the economic environment has to throw at it. The firm has a balanced capital allocation strategy with significant cash returned to shareholders in recent years. Emerging market growth and infrastructure investments are key sources of expansion.
• Reduced reliance on GE Capital Corp (NASDAQ:GECC) remains a sound trajectory. Not only do we think that increased transparency and potential monetization of a portion of its far-reaching financial operations is a prudent idea, but the move also frees up the executive suite to focus on driving top-notch performance at its industrial operations.
• GE boasts a very nice dividend yield (~3.1%), and its Dividend Cushion ratio is solid (3.1). The firm has paid an amazing $150+ billion in dividends since 1970. It is one of our top ideas and expects to return another ~$8 billion to investors via dividends in 2016.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. General Electric's 3-year historical return on invested capital (without goodwill) is 26.1%, which is above the estimate of its cost of capital of 8.9%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. General Electric's free cash flow margin has averaged about 12.9% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At General Electric, cash flow from operations decreased about 10% from levels registered two years ago, while capital expenditures fell about 46% over the same time period.
We think General Electric is worth $32 per share with a fair value range of $27-$37.
The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 2.5% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -7.3%.
Our model reflects a 5-year projected average operating margin of 18.6%, which is above General Electric's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2% for the next 15 years and 3% in perpetuity. For General Electric, we use a 8.9% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $32 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for General Electric. We think the firm is attractive below $27 per share (the green line), but quite expensive above $37 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate General Electric's fair value at this point in time to be about $32 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of General Electric's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $39 per share in Year 3 represents our existing fair value per share of $32 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.