General Electric: Show Me The Way

Summary

• Four companies are showing General Electric's management team what they need to do to create value in 2018/2019.
• After considering the risks, I believe General Electric is still worth a look.
• I'm staying long General Electric.

General Electric (NYSE:GE) is a company in turmoil, as this once-great industrial conglomerate has had to fend off the bears while at the same time try to reassure investors that the boat is not sinking. To say that the bears have been winning the fight over the last few years would be the understatement of the year because GE shares have underperformed the S&P 500 by a wide margin over this period of time. Consider this - GE shares have underperformed the broader market by ~160 percentage points over the last 10 years.

GE data by YCharts

As a long-term GE shareholder, this chart hurts (more on this below). It has been hard to stay the course with GE over the last 12 months (full disclosure: I sold one-third of my position last month for around $15.50 per share), but I continue to believe that there are reasons to stay long the stock in 2018.

The most significant catalysts for this stock, in my opinion, all revolve around the value that could be unlocked by management by streamlining operations, focusing on the core businesses, and winning over the market (i.e., improving investor sentiment). Yes, easier said than done. However, I believe that there are four companies that are showing GE's management team what needs to be done in order for this storied conglomerate to finally turn the page.

Show Me The Way

Mr. John Flannery, CEO, already announced plans to dispose of $20B in assets over the next few years, but I believe that this company will need to make a bigger splash. Why? Simply put, GE in its current state is too complex to manage.

Several companies already have provided GE with a framework that should allow for Mr. Flannery and team to change the narrative for this industrial conglomerate. The latest trend has been for large companies to dispose of "non-core" businesses to unlock value and focus on their core operations, with the following being the most relevant examples:

• Honeywell (HON) - Plans to spin off its Homes and Global Distribution and Transportation Systems units into two separately traded companies by the end of 2018.
• United Technologies (UTX) - The company's CEO recently floated the idea of breaking up UTX into multiple separately traded companies. This plan is not concrete but I do believe that some type of asset sales will occur over the next year or so.
• DowDuPont (DWDP) - The company will split into three separately traded companies by the end of 2019. This is a slightly different situation, as Dow Chemical and DuPont initially planned to spin off assets prior to the merger, but the story is the same (i.e., disposing of assets to create more manageable, valuable companies).
• Siemens (OTCPK:SIEGY) - The company plans to spin off its Healthineers division in the first half of 2018.

Not all of these examples are direct comparisons; but, in my opinion, the proposed plans (or rumored plans) are all direct attempts to unlock value by streamlining operations and focusing on core businesses. This is, in my mind, exactly what GE needs to do at this point in time.

It is hard to deny the fact that GE has some great industrial businesses in its portfolio. Moreover, I believe that significant asset sales/spinoffs are not only necessary but are critical to General Electric's long-term success. To this point, it will be a case of addition by subtraction if management finally sees the light and follows in the footsteps of these other large companies.

Addition By Subtraction?

GE already announced a deal to sell its overseas lighting business and the company is reportedly seeking a buyer for its industrial gas engine business, so it's not like management is sitting on their hands. However, I believe that more needs to happen sooner rather than later.

In my opinion, shrinking is the way to go for GE. Moreover, it was recently reported that Siemens is expected to receive proceeds in the range of $4.8B-5.7B from a public offering of its medical imaging and diagnostics division (the Healthineers unit) which is projected to be valued around $38B.

Source: Siemen's 2017 Annual Report (in euros)

In U.S. dollar terms, the numbers are closer to roughly $11.5B (revenue) and $2.1B (profit) - again, this is a rough estimate. So, how does Healthineers compare to GE's Healthcare unit?

Source: GE's 2017 10-K

As shown, GE's operating unit is a lot bigger and it has around the same margin (~18%).

The Healthineers unit would trade around 3.3x sales and 18x profit if the $38B valuation turned out to be right. Therefore, GE Healthcare would be valued in today's market in the range of $63B-60B if the same metrics were applied. This is half of GE's current market capitalization.

This is indeed an overly simplistic way to compare these two operations units, but at the end of the day, this analysis should show you the type of value that GE's Healthcare could fetch in the market. Moreover, the analysis shows just how undervalued the stock is if (yes, a big "if") management is able to right the ship and take care of the other stuff - e.g., Power issues, SEC investigations, pension troubles, etc.

Plus, GE's Aviation unit, which is the most valuable business, is another potential asset that could be disposed of, if need be.

The Risk To Consider

The pundits who are predicting for GE to eventually file for bankruptcy are way too premature in their assessment. Of course, only in my opinion, but there are definitely plenty of risk factors that need to be considered before investing in this industrial conglomerate. In my mind, the No. 1 risk is related to the chart provided in the introduction of this article, which shows how bad GE shares have underperformed through a bull market (i.e., the opportunity cost). I believe that the risk for GE is to the upside if you are willing (and able) to look out three-to-five years. But the near-term stock performance is indeed a significant concern.

I do not believe that GE shares will outperform the S&P 500 over the next 12 months, but looking out, I anticipate for this company to be a market beater over the next 3-5 years.

Valuation

GE's stock is trading at an attractive valuation, but shares are cheap for a good reason.

GE PE Ratio (Forward) data by YCharts

Again, GE does not deserve to trade at a premium, especially when compared to its peers, but 14x forward earnings estimates is too cheap. The SEC investigations and further downward pressure for the Power unit have the potential to drag the stock below $14 per share, but I believe that most of the bad news is baked into the stock price.

Let's also not forget that the business environment is projected to improve in early 2018, as described by FactSet:

During the first two months of the first quarter, analysts increased earnings estimates for companies in the S&P 500 for the quarter. The Q1 bottom-up EPS estimate (which is an aggregation of the median EPS estimates for all the companies in the index) rose by 5.7% (to $36.32 from $34.37) during this period.

Source: FactSet

The 5.7% increase may not seem like much, but notice the negative trend over the last few fiscal years. In addition, the 5.7% for Q1 2018 was the largest increase in estimates over the first two months of a year since FactSet started tracking this metric in 2002. This improving backdrop is great news for a company like GE and, in my opinion, will only get better if President Trump is able to push through an infrastructure bill.

Bottom Line

I have stated this several times in the past, but to clarify, I do not expect for GE to be a market beater over the next year. However, I do believe it has some great industrial businesses that have promising long-term business prospects. So the company's future definitely looks brighter than what has played out over the past two years.

GE should follow the lead of the other companies that are disposing of material businesses because, in my opinion, this company needs major changes to occur to truly change the narrative. If this happens, a tremendous amount of shareholder value will be created.

Additionally, the newly elected board members are important to this company's long-term success and I have no doubt that the new blood will usher in a new era of accountability. As such, investors with a long-term perspective should treat significant pullbacks as buying opportunities.

Disclaimer: This article is not a recommendation to buy or sell any stock mentioned. These are only my personal opinions. Every investor must do his/her own due diligence before making any investment decision.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Disclosure: I am/we are long GE, UTX, HON. 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.