General Electric Is A Very Strong Buy

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About: General Electric (GE), Includes: BHGE, BRK.A, BRK.B, UTX
by: Olukayode Jinadu
Summary

General Electric is undergoing several massive changes to its portfolio, including the spin-off of its Oil and Gas division and the sale of its Lighting division and Transportation division.

The company is using these sales and spin-offs to pay down debt and reduce liabilities in order to make its financial position much stronger.

The planned spin-offs of the Oil and Gas division and the Healthcare division are good for existing shareholders because they can obtain shares in these businesses during the spin-offs.

The spin-offs will make GE a more focused company around Power, Renewable Energy and Aviation, which now opens it to a potential merger with other Aerospace companies like United Technologies.

Investment Thesis

General Electric (NYSE: GE) is a very strong buy and is selling at a very attractive valuation. It is truly a great buy that can easily give investors more than a 100% return.

Introduction

GE is a huge conglomerate with over a century of history that operates in several major industries, including energy, transportation, healthcare, financial services and aviation.

Warren Buffett Likely to Move to Buy GE

Famed investor Warren Buffett is known for looking for undervalued investments that present a compelling long-term advantage, and he is interested in companies that are selling at an undervalued discount relative to its fundamentals. Also, he looks for companies with a wide moat and great management but that are mispriced due to some temporary events. With Buffett at the tail end of his career, there is no better opportunity currently than General Electric. He has invested in the company in the past, and it has a long-storied history as one of the most successful companies of the last 100 years. So, it’s a company that Buffett would invest in, to make a big splash at the end of his long, storied career.

Segment Analysis

GE Power

2017

2016

2015

Revenue

36

36.8

28.9

billion

Profit Margin

7.8%

13.9%

16.6%

Backlog

98

billion

GE Power is the company’s largest division. It manufactures gas and steam turbines, engines, generators, and high-voltage equipment and provides power-generation services and digital solutions. GE Power’s revenue grew from 2015 to 2017 because of demand for power generation equipment, but its profit margin dropped during this period because of overcapacity driving down pricing/margins as well as lower demand for service upgrades. GE management is planning to keep GE Power even though it is spinning off several other divisions. The division's backlog showed modest growth of only 3%, which caused worry among management because of the softening growth in power demand. The growth expected from traditional power is now going to renewables.

Renewable Energy

2017

2016

2015

Revenue

10.3

9

6.3

billion

Profit Margin

6.8%

6.7%

6.3%

Backlog

15

billion

GE Renewable Energy is a manufacturer of onshore and offshore wind turbines, wind turbine blades, and hydropower solutions. Its revenues and profit margin increased from 2015 to 2017 because of strong revenue and orders growth, new product introductions, and new digital capacity. GE Renewable also saw a 15% increase in backlog due to increases in overall renewable energy demand worldwide. Its backlog was boosted by it securing orders from the largest wind farm in Australia - the 453 MW Coopers Gap Wind Farm in North Queensland. GE needs to invest heavily in this segment to boost orders because this is the company’s future. GE Renewable Energy has the potential to become the largest division of GE in the next 10 years. This strongly supports the investment thesis and is also a good sign for Warren Buffett.

Oil and Gas

2017

2016

2015

Revenue

17.2

12.9

16.5

billion

Profit Margin

1.2%

10.9%

14.5%

Backlog

21

billion

GE Oil and Gas provides oilfield services, oilfield equipment, turbomachinery, process solutions, and digital solutions. The oil and gas segment comprises 62.5% of Baker Hughes GE (NYSE: BHGE) following the combination of GE Oil and Gas with Baker Hughes in July 2017. GE Oil and Gas’s revenues increased from 2015 to 2017 because of increased business in oilfield services and digital solutions for oil and gas with GE’s purchase of Baker Hughes, but the post-merger integration and clash of cultures resulted in a crash in profit margin, and GE is looking to sell off or spin off the Oil and Gas division, as it is no longer compatible with the company’s long-term goals. This is also a value-creation opportunity for investors that agrees with the investment thesis: in the event of a spinoff, shareholders who buy GE stock will get shares from the spinoff of BHGE. Backlog growth remained flat in 2017 primarily because of the soft price of crude oil.

Aviation

2017

2016

2015

Revenue

27.4

26.3

24.7

billion

Profit Margin

24.1%

23.2%

22.3%

Backlog

170

billion

GE Aviation manufactures commercial and military engines, aviation systems, and additive manufacturing machines. GE should look at merging this division with a slimmed down United Technologies (UTX) without Carrier and Otis. This will be a great merger that will yield a world-class Western player to take on the competition in aviation to come from China. GE Aviation can easily be merged with Pratt & Whitney, a division of United Technologies, and huge cost synergies be realized by eliminating overlaps. GE Aviation’s revenues and profit margin increased from 2015 to 2017 because of growth in commercial and military services offsetting margin pressure from the ramp-up of the LEAP engines. The LEAP backlog also drove the 10% increase in the $170 billion backlog. GE can basically merge this division with United Technologies and keep United Technologies a publicly traded company, with GE and minority shareholders owning the company. This will create an aviation powerhouse that the world has never seen, with pieces including United Technologies’ legacy aerospace business, Goodrich (acquired in 2011 by United Technologies), Pratt & Whitney, and the newly acquired Rockwell Collins and GE Aviation. It will be an amazing portfolio.

Healthcare

2017

2016

2015

Revenue

19.1

18.3

17.6

billion

Profit Margin

17.8%

17.5%

16.5%

Backlog

18

billion

GE Healthcare provides healthcare diagnostic imaging and clinical systems, life sciences products, and services and digital solutions. Its revenue and profit margin increased from 2015 to 2017 because of the customer demand for integrated precision health solutions as well as increased analytics capability.

Capital

2017

2016

2015

Revenue

9.1

10.9

10.8

billion

Profit Margin

-74.7%

-11.9%

-74.1%

GE Capital provides industrial-aligned financial structuring and product support for GE businesses, including in aviation, healthcare, power, and renewable energy. This is a very important division because it provides the financing that allows GE to conduct financing deals with its customers. GE Capital’s revenues and profit margin decreased from 2015 to 2017 because of charges related to increased reserves for its insurance operations. Also, GE Capital will require $15 billion in capital over the next 7 years. GE Capital is needed but has too many liabilities, and some pieces of it have already been spun off, like Synchrony Financial. The reality is that the portfolio needs to be reviewed again, and more liabilities need to be spun off from the division. It is losing far too much money, and no company or division can survive with billions of dollars in losses.

The transportation and lighting businesses, while part of GE’s 2017 annual report, are no longer part of the company’s portfolio because they have been sold off. Some of the sales and spinoffs and restructuring at GE Capital didn’t happen fast enough, and this led to GE's board of directors bringing on a new CEO, Larry Culp, in 2018. GE could have gone further and split the Chairman role from the CEO role and given the Chairman role to a higher-profile person potentially from outside the United States - like Carlos Slim Helu - that knows how to deal with governments around the world. Its long-term goal of focusing on Energy and Aviation requires expertise in dealing with governments.

Financial Analysis

GE

Profitability Indicator Ratios

2017

2016

2015

Gross Profit Margin

24.70%

29.27%

29.55%

Operating Profit Margin

9.73%

14.42%

14.36%

Profit Margin Analysis (Net Profit Margin)

-4.74%

7.68%

1.45%

Return on Assets

-1.56%

2.21%

0.30%

Return on Equity

-9.00%

12.52%

1.73%

GE’s gross margin decreased from 2015 to 2017 because of increases in the costs of goods sold and services. Its operating margin decreased from 2015 to 2017 because of increases in sales, general, and administrative expenses. Net profit margin decreased from 2015 to 2017 because of investment contracts, insurance losses, and losses in insurance annuity benefits. The loss of investment contracts swung GE from weak profitability in 2015 to outright loss in 2017. The company’s return on assets and equity dropped sharply from 2015 to 2017 because of its losses in 2017.

GE

Debt Ratios

2017

2016

2015

Debt Ratio

83.00%

79.24%

80.05%

Capitalization Ratio

63.24%

58.18%

60.01%

Interest Coverage Ratio

-0.81

2.80

3.36

Financial Leverage Ratio

5.78

5.66

5.81

GE’s debt ratio remained flat from 2015 to 2017 because total borrowing kept growing. The long-term portion of the borrowing is tied to GE Corporation (the oldest senior notes are due in 2055) and the subsidiary, GE Capital. This may be an opportunity for GE to look at selling off GE Capital to reduce long-term liabilities. GE’s capitalization ratio remained above 50% from 2015 to 2017 because of its high proportion of funding from long-term debts rather than from shareholder equity. The company’s interest coverage ratio collapsed from 2015 to 2017 because of a sharp drop in profitability. Its financial leverage ratio remained high from 2015 to 2017 because of drops in shareholder equity due to a more than 10% drop in retained earnings over this period.

GE

Investment Return

2017

2016

2015

Price/Book Value Ratio

1.85

3.65

2.95

Price/Earnings Ratio

-20.54

29.16

170.74

Price/Sales Ratio

0.97

2.24

2.47

GE’s price-to-book value dropped, primarily because of the sharp drop in its stock price from $30.71 at the end of December 2015 to around $14 in May 2018. This sharp drop was obviously because of the weakened profitability over this time frame, which has made the company much cheaper, potentially moving it into value territory, where Warren Buffett has operated throughout his 60-year career. GE’s price-to-earnings ratio swung sharply from triple digits to a negative value from 2015 to 2017. The number primarily reflects its weakened profitability during this period. GE’s price-to-sales ratio also dropped from 2015 to 2017, which is another sign that the stock had become much cheaper during this period.

Conclusion

Warren Buffett will be looking to buy into GE at its attractive price. He will likely buy the stock currently or to seek a deal for one of its subsidiaries. The company is currently looking to divest $20 billion in assets, which gives Buffett an opportunity to buy at attractive valuations. GE is looking to trim down its exposure to its traditional power businesses and to sell its transportation, lighting, and healthcare businesses. Additionally, it is looking to spin off the oil and gas business. Furthermore, GE can merge with United Technologies to create a world-class aerospace division. These businesses are complementary to businesses that Buffett already owns: the power business is directly complementary to Berkshire Hathaway’s (BRK.A, BRK.B) energy business, and the transportation business is directly complementary to Burlington Northern Santa Fe. Warren Buffett will see many synergies between GE’s portfolio and Berkshire’s current subsidiary businesses, so he will be a buyer at a very attractive price.

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