Shares of General Electric (NYSE:GE) are trading down roughly 2% after reporting a quarter that was generally in line with analyst expectations (press release available here). In the quarter, the company earned $0.53 excluding items on $40.54 billion in sales compared to street expectations of $0.53 on $40.38 billion. Earnings were up 20% from last year. While the stock is not reacting well to the numbers (likely due to profit taking after a 14% run in the past six months), I think there was a lot to like in this quarter. These numbers confirm my optimism, and this dip is to be bought.
GE is trying to shift back to its industrial roots and away from its financial unit, and this transition continues to progress nicely. Organic industrial revenue growth was up 5% year over year, and full year operating EPS was up 9% to $1.64. Margin expansion has helped to drive EPS growth as margins expanded 100bp in the fourth quarter to 18.3%. While sales were up 5%, new orders were up 8%, which suggests revenue growth will accelerate in 2014.
Boeing's (NYSE:BA) aviation segment has played a major role in GE's new orders as it is the major engine supplier to the new Boeing 777x. Based on jet orders from the Dubai Air Show alone, GE received $40 billion in orders at list price, which will make aerospace its leading growth unit (it already accounts for over 20% of industrial revenue). The total industrial backlog stands at $244 billion, which translates to 18-24 months of revenue.
GE is one the world's largest manufacturers, and it has positioned operations to benefit from two secular growth trends. First, GE has become a major oil & gas supply company, and revenues were up 17% in the fourth quarter. U.S. energy production is growing dramatically thanks to horizontal drilling, which has made reserves accessible. Major finds in the Marcellus and Utica Shale and Permian Basin will also drive increased production activity for some time. GE is perfectly positioned to provide equipment for these wells, and revenue should continue to grow thanks to the massive amount of untapped oil and natural gas in the United States.
Importantly, revenue growth accelerated in the fourth quarter from the annual 11% pace, and I expect another year of double-digit growth in 2014. Moreover, profits in the quarter grew by 24% to $802 million. As the country slowly starts to export natural gas, there is significant production growth potential, which will power GE's unit to new heights. Exposure to oil & gas is a major reason to own GE.
Second, the company's aviation unit soared 13% year over year to a robust $6.17 billion in sales, up 13% year over year. By 2015, this unit should account for over 25% of GE's industrial revenue. In the U.S., airlines are more profitable than ever thanks to consolidation, and global demand for new jets is strong thanks to developing economies in Asia. Profitability at this unit was up 20% year over year. While investors like to say GE isn't a growth company, if you look under the hood and at individual units, you see GE is profiting from two major growth trends: aviation and oil and gas. These units will drive significant topline growth while other units like healthcare, appliances, and transportation continue to grow in the 3-7% range.
GE has also made the wise decision of shrinking GE Capital to a more manageable size after letting it get too big and risky before the financial crisis, endangering the whole firm. We now have a smaller but leaner GE Capital that can deliver profits without reaching out of its core competency into credit cards, real estate, and risky loans. Due to its smaller size, revenue was down 5% though profits were up 38% thanks some one-time gains. Tier 1 common capital is extremely strong at 11.4%, which will allow Capital to pay larger dividends to the parent company (which can be used for acquisitions, dividends or buybacks). Net interest margin is also robust at 5%.
Going forward, GE Capital will grow alongside GE's industrial units, financing those purchases while the unit's extraneous activities will continue to shrink. Total assets at GE capital are down $21 billion year over year to $512 billion with cash accounting for over 20% of that total. Even though the business is shrinking, shareholders' equity grew 2% to $83.7 billion.
A sum of the parts analysis suggests that GE still has further upside. At the moment, GE has a market capitalization of roughly $267 billion. Giving GE Capital a valuation of 1x book value (which is on the conservative side given robust net interest margin), GE's industrial units are being valued at $183 billion. GE aviation is benefiting from the boom in Boeing's orders and should be given a similar valuation. Boeing is trading at about 23x earnings. With full year income of $4.345 billion at its aviation unit, that business is worth $100 billion. Its oil and gas unit would trade at about 17x earnings based on peer valuations, which would give it a worth of $37 billion. That means the rest of GE's operations are being valued at $46 billion. For reference, they earned $18 billion in segment profits, which means its units are being valued at less than 3x segment profits.
Even if investors valued these units at 9x segment profits, that means GE is undervalued by $108 billion or $10 per share. In other words, GE has another 35-40% of upside from here. This quarter showed growth units continue to perform well, and GE Capital's transition is going smoothly. Shares should be trading higher not lower on these numbers, and I would buy GE at current levels.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in GE, over 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.