Given concerns about a double dip, many investors are looking to diversify their portfolios. Conglomerates provide an ideal way to spread out capital through various sectors and industries. Even still, they often come with significant volatility depending on what sectors they are invested in. General Electric (GE), for example, has largely become a financial (and is even categorized as one on Google Finance). Accordingly, it has a high beta of 1.6. By contrast, 3M (MMM) is invested in stable sectors, like healthcare, protection services, and fixtures, and, accordingly, has a low beta of 0.9. Tyco International (TYC) falls between these two conglomerates in terms of liquidity and focuses on electronic security, fire protection, and control systems.
In this article, I will run you through my DCF model on Tyco and then triangulate the result with a review of the fundamentals against 3M and GE. I find that GE is the most undervalued of the three.
First, let's begin with an assumption about the top-line. Tyco finished FY2011 with $17.4B in revenue, which represented a 2% gain off of the preceding year: acceleration. I model 11.8% per annum growth over the next half decade or so.
Moving onto the cost-side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I model cost of goods sold as 62% of revenue versus 27% for SG&A and 7.5% for capex. Taxes are estimated at 27% of adjusted EBIT (ie. excluding non-cash depreciation charges to keep this a pure operating model.)
We then need to subtract out net increases in working capital to get free cash flow. I model this metric hovering around -3.5% of revenue over the explicitly projected time period.
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 10%, I find a fair value figure of $40.91 for 26% downside to the close of trading on May 11, 2012. My model also calculates around $2B worth of free cash flow by 2017, which means the current price-to-2017 free cash flow multiple is 12.7x. This makes the stock fairly expensive. Nevertheless, the stock continues to be appreciate on the Street. According to NASDAQ, it is rated near a "strong buy". Here's why...
All of this falls within the context of solid operating performance:
"Our second quarter performance was highlighted by strong organic revenue growth. Order momentum over the last few quarters, coupled with continued growth in our ADT Residential business continues to drive higher top line growth. Our large and stable base of recovering and service revenue, which represented 45% of our revenue in the quarter, coupled with strong operating leverage led by the Fire and Security manufacturing businesses drove the operating performance of this quarter".
From an earnings multiples perspective, Tyco appears more undervalued than what my DCF model suggests. It trades at a respective 18.2x and 13.2x past and forward earnings. Corresponding figures are 15.6x and 10.8x for GE and 14.3x and 12.4x for 3M.
Consensus estimates forecast GE's EPS growing by 13.1% to $1.55 in 2012 and then by 13.5% and 18.2% in the following two years. Assuming a multiple of 14x and a conservative 2013 EPS of $1.73, the stock would hit $24.22 for 21.6% upside. GE is led by terrific management, but carries more risk than what a cursory analysis suggests. GE Capital continues to represent a sizable portion of business and carries systemic risk from capital market volatility. This risk will enable higher returns as execution undermines bearish fears.
Consensus estimates forecast 3M's EPS growing by 7.4% to $6.40 in 2012 and then by 9.1% and 8.5% in the following two years. Of the last 13 revisions to EPS, all have gone up for a net change of 1.3%. According to NASDAQ, the stock is rated around a "hold". Assuming a multiple of 14x and a conservative 2013 EPS of $6.95, the stock would hit $97.30 for 12.2% upside.