General Electric (GE) is currently a strong buy. GE's share price is extremely depressed at the present moment which was caused by a high degree mismanagement and a large drop in earnings over the last ten years. These days are quite clearly behind GE, and the prospects for the firm are bright. A substantial amount of restructuring has occurred which will lead to a long-term rise in earnings. There are two fears that an investor might have when looking at a stock like GE. The investor might be worried about insolvency, and an investor might be worried about when earnings will start to rise again. Neither of these is a concern at present as GE's operating income far surpasses their current interest expenses, which demonstrates that GE has a manageable debt load. The bleed that has been damaging the firm's financial strength is mostly due to a few underperforming segments as well as an underfunded pension plan. All of this is known by management, and they are intelligently addressing these concerns making this an advantageous time to initiate a multi-year long position in GE. As GE stands to enter a new period of prosperity while GE stops shrinking and begins to grow once more. Within the last few days, GE replaced their CEO; the new CEO Lawrence Culp seems poised to continue to execute this strategy effectively.
To completely describe everything that is happening and has been happening in GE would be tantamount to writing a book. I will be seeking to highlight the qualitative factor that I think is the most important, which is the intelligent long-term strategy I see being executed in the last three years. I am aware that an investor who has seen their share price drop like a rock might disagree with this. But GE was not broken overnight, nor will be fixed overnight. GE is reaching the end of a multi-year transitionary period and is poised to regain at least some of what was lost. For an outsider who has not held GE stock this entire time, now is a cheap opportunity to establish a position in the stock.
The fact that GE is replacing John Flannery as CEO with Lawrence Culp almost seems unnecessary. To be clear, I think Mr. Flannery was doing an acceptable job at turning around GE. The addition of this new CEO doesn't have much of an impact on the direction that I think GE will be moving in. Since I do not know this new CEO, I cannot add anything more to the conversation about his merits as CEO of GE and would refer to what was reported about him in the Wall Street Journal. It seems likely that GE will remain on the same trajectory that previous CEOs have set based on the article about him, the trend that can be seen in GE accounts would seem in line with how he conducts business. Specifically, referring to cost-cutting and streamlining efficiency, which will be discussed more thoroughly in the quantitative factors section.
All these changes in management in the last three years does prohibit me from doing much more than speaking in general terms about the direction of GE. Mr. Flannery was following an intelligent approach of delevering the balance sheet and focusing on increasing cash flow. I have always taken the view that a business is only worth its cash flows, with few if any exceptions and Mr. Flannery's strategy was music to my ears. I am in large support of putting a business through short-term pain to reposition it for the future.
Short-term pain has very much been the story at GE for the last three years, large portions of the enterprise that were underperforming have been sold off or are currently in the process of being sold. GE Capital and GE Power are the two most impactful segments to discuss. Both are responsible for a large enough portion of the underperformance of the enterprise. GE Capital was involved in mortgage lending and long-term care insurance; long-term care insurance proved to be a major landmine for the insurance industry as a whole. Meanwhile, GE Power was kind enough to create a non-competitive inventory that sat around collecting dust. Both of these factors produced a long-term drag that has largely been corrected.
GE Power has been drastically shrunk in size and underperforming assets eliminated. GE Power continues to cut costs and shrink to fit the size of the industry that it intends to serve. It is noteworthy, however, that revenue has marginally increased at GE Power during this time. GE Capital has similarly been scaled down and will focus on helping customers finance the purchase of other GE industrial products. The Mortgage and Insurance days are long gone at GE Capital. While there might be some lingering expenses from this, it can safely be said that GE is now moving past these issues.
Jumping right into the quantitative factors, revenue is up 4.7% since 2015. The increase is extremely important to pay attention to since it demonstrates that management has halted the decline in revenue and is slowly starting to reverse it. But this rise in revenue has not translated into a rise in operating income, as revenue has increased 4.7%, operating income has dropped by 57%. However, it is this revenue and the cash flow from it that generates the indicator of brighter days ahead.
This chart was taken from page 189 of the 2017 Annual Report. It shows the revenues that were generated by each different segment of GE's business. Revenues were only down for GE Capital and Lighting over this three-year period. It is very important to note the revenue from the ever-troublesome GE Power has been going up during this time as well. I cannot overstate the importance of this as an early indication that the turn around at GE is going well. This, of course, all comes back to revenue recognition and the difference between cash flow and income. It is even more important when the former CEO Flannery explicitly stated that his goal was to improve the firm's cash flow. Much of the deferred revenue is in future service and maintenance contracts on the equipment that GE sells. The deferred revenue creates a secondary stream of cash flow for the business that rises and falls with overall revenue. It also will have a delayed effect on the income statement as it will reappear there once it is recognized as earned revenue.
Since this secondary cash flow has been steady for the last three years, it would seem to indicate that the decline in operating income was caused by non-reoccurring events. This also is visible in the interaction between net income and operating cash flow, as they have had no correlation to each other in the last three years, and both have been lower while revenue has risen. This could be interpreted as meaning that the cost of doing business has risen for GE in the last three years. Well, if that was true, then both recognized revenue and deferred revenue should be affected in tandem. As the amount GE can charge for performing maintenance on a product is related to the production cost of the product. If making the product is getting more expensive, then fixing it should be getting more expensive too. Thus, causing cash flows and net income to behave in a related manner. Since this is not occurring, one can be assured that the odd behavior in the financial statements is simply the by-product of management reshaping the business. Thus, making it irrelevant to my long-term consideration of purchasing stock.
It is also very important to note that debt has been dropping like a rock during this time as well. Short-term debt is down by about 50% in the last three years and long-term debt is down by 34% over the same period. The firm is sitting on $80 billion in cash and cash equivalents and is following a conservative growth plan to get their pension fund back on track. But it is noteworthy the GE could easily cover the pension shortfall with cash on hand. But if the GE pension fund manages to maintain the projected approximate 4.5% annual growth, the pension fund should be fine for the future. Again, I see bright blue skies ahead for GE and prosperity for its investors as its financial strength has stopped dropping and finally continues to improve. Any fears of an endless free fall or bankruptcy should be in the rear view mirror for everyone.
GE has been winning for a very long time as it is not a new enterprise. Recently, this business has lost its way, which led to the share price plummeting, a couple of changes in CEO, and caused GE's financial statements to be a complete mess with all the different changes that have been occurring so rapidly over the last few years. However, the core of GE's business is solid, and if an investor can stomach all of the unexpected change and uncertainty they can purchase shares in a business that is on its way back to prominence at a dirt cheap price. I would caution though that I do expect the pay off from investing in GE to appear over the next year. It may take five years for the full value of GE to once more be reflected in its share price, thus purchasing a call option might be premature at this time, where purchasing the stock would not be.
GE is quite an unique opportunity right now; such an old large business would typically find its growth constrained by its size. But GE was kind enough to shrink itself and plummet in price, allowing possibly of a more generous growth rate, creating an attractive buying opportunity for new investors. I see no reason to think that GE won't regain its EPS of 1.72 that it had in 2008 at the bottom of the financial crisis, over the next five years. With a below average PE of 15 that would equal a share price of $25.8, this would equate to an annual return of 13.83%. I should explain that I do not believe in making precise predictions of future stock prices. I view that as a fruitless endeavor that is filled with error, this is intended to be a general forecast not a precise prediction.
Disclosure: I/we 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.