Why GE Is Overvalued

Summary

• A breakdown of GE's business segments and how they have been impacted by the pandemic.
• Direct, Indirect, and DCF Valuation of GE equity.
• Sell recommendation with a price target of $8.57.

General Electric (GE) Equity Valuation

SELL

Price Target: $8.57

Overview

General Electric is a worldwide, high tech industrials company comprised of four major market segments: Power, Renewable Energy, Aviation, and Healthcare. In addition, they also have a financial services division, GE Capital, that mainly focuses on aircraft financing and leasing. Like many companies in the sector, GE has faced a declining demand for most of its products and services due to the COVID-19 pandemic. To demonstrate the scale of each segment and how they have been affected by the pandemic, I have put together the charts below, that compare Q3 revenues for 2019 and 2020.

GE is in the midst of significant corporate restructuring as new management intends to reduce total leverage (cut fixed costs and pay down debt) and put a heavy focus on generating positive free cash flows to the firm. While this strategy is necessary in a time of receding demand, I have worries about GE’s planned reduction in research and development spending as this could lead to the company no longer being a leader in innovation, thus shattering any chances of long-term top line growth.

Industrials Overview

The industrials unit is comprised of four segments: Power, Renewable Energy, Aviation, and Healthcare. The core functions of these businesses are to both sell, install and service large engines, turbines, or any equipment of the like. 51% of Industrials sales fall into the service category compared with 25%-25% for competition. This is important to note as the profit margin for equipment sales are only 4% while services are between 20%-30%. In essence, GE’s industrials unit relies on the razor blade business model where the bulk of profits are earned during the equipment’s life through servicing revenue. This is a key moat for GE, as they are one of the only companies with the required expertise to service their own equipment.

Power

Coal and gas power have helped GE become the global energy turbine producer it is today. In Q3 this segment recorded revenue of $4.025 billion a 3% increase YoY with a segment profit of $150 million, coming out to a 3.72% profit margin. Recently, demand for these non-sustainable sources of energy have been declining worldwide, especially in developed countries. GE is essentially trying to squeeze as much cash as possible out of the remaining gas generated electricity market until demand in the industry becomes small enough to no longer make the endeavor profitable. GE announced in Q3 that they will be exiting the coal power market due to bleak long-term growth prospects. In my opinion, we could see this trend carryover into the gas power unit in the distant future. Taking a look at the graph below, we can see how demand for coal, and to a lesser extent natural gas, are on a downward trajectory.

Renewable Energy

The Renewable Energy arm of GE’s business shows some promise for growth into the future. The COVID-19 pandemic has resulted in the US Government extending the Production Tax Credit’s usage into 2021 and 2022 to qualify for 100% and 80% PTC respectively. The extension of these tax credits will cause more businesses to transfer to renewable energy, thus driving demand. Additionally, I suspect the Biden administration will continually incentivize the private sector to transfer to renewable energy in the form of tax credits. GE has focused its R&D in this segment as customers have realized the potential for larger, more efficient turbines that reduce the average cost of energy. Unfortunately, the largest area of growth potential GE has, has an extremely thin profit margin. Total revenue for the segment came in at $4.525 billion while they barely broke even recording a profit of just $5 million. As growth continues, GE’s operating leverage should allow for an increased profit margin. The diagram below, shows the growth of wind and solar power throughout the past 20 years, I would not suspect this trend to reverse anytime soon.

Aviation

The aviation segment is directly correlated to global air traffic. Obviously, this segment took a massive hit during the pandemic and as a result GE has tried to cut costs as best, they can. GE cut nearly 25% of its workforce, saving nearly $1 billion, in an attempt to resize the business in accordance with demand. As in any trough in the business cycle companies are too slow to fire, and too slow to hire during the recovery stage. Management’s execution of hiring in accordance with market demand will be essential for GE to maintain their dominate market share in the industry.

As we return to normal, which we will be sooner than the market expects, so will the aviation industry. Boeing and Airbus expect worldwide commercial fleets to double over the next twenty years, which would certainly be a major tailwind for the segment. I would take these predictions with a grain of salt as there is some inherit bias due to Airbus and Boeing’s business operations.

Healthcare

Healthcare is the segment of GE in which I am most excited by and has the potential for not only sales growth, but profit. GE saw a short-term hit to demand in the space as elective surgeries and diagnostics were put on hold, until rebounding in Q3. GE continues to innovate within the space and introduced two new products in Q3 that leverage artificial intelligence to alleviate clinical strain on radiologists and increases efficiency in its entire Vivid cardiovascular ultrasound portfolio. The path to growth and market domination for GE is continual research and development within healthcare to stay ahead of the competition. Unfortunately, management has not signaled this aggressive attitude whatsoever and is focused on reducing total leverage (paying down debt and reducing fixed costs).

Capital

GE capital focuses on financing and leasing commercial airplanes. Through the pandemic GE has seen increased deferrals for lease payments as airlines struggle with liquidity. Management believes these deferrals will be short lived, but in my opinion these liquidity struggles will lag the airline industry recovery due to the damaged balance sheets of most airlines (increased debt). This segment received $1.681 billion in revenue for Q3 while recording a loss of $52 million. The segment took a $104 million loss from continuing operations which is mostly comprised of debt payments for assets that have been sold. This loss will be reduced going forward due to falling interest rates and debt principal reduction. Looking forward this segment will live and die by the airline industry recovery which I am bullish on.

To Recap

On the qualitative front, GE has its pros and cons with opportunity in healthcare and renewables, but major headwinds in power and capital. Additionally, the impending airline recovery will benefit GE, however, if this is your investment thesis, I would consider looking into a less diversified company within the airline industry such as Boeing. Usually, value companies such as GE will provide investors with competitive dividend yields, however throughout the past 5 years GE’s yield has never risen above 1% as the company struggles with generating cash flow. The graph below shows GE’s stock price and dividend yield since 2016.

Quantitative Evaluation

For my valuation of GE, I used a variety of techniques. First, I used comparable analysis where I gathered multiple similar companies to GE and sorted them based on value drivers. After this I determined the best four comparable companies, by sorting on value drivers, out of the data set which are shown below.

After extracting the market multiples at which these companies trade at currently, I was able to then focus on the multiples with the least variation among the four comparable companies and used those to determine a price per share. In my direct valuation I used both price to earnings and price to cashflow as the deviations for the comp’s set where close to 0%.

Next, I multiplied the median multiples to GE’s earning and operating cashflows respectively to arrive at an implied price per share of $6.462 and $9.7559. After averaging these two implied prices I received a direct valuation of $8.11.

For my indirect valuation I used the same comparable companies and looked for multiples with little variation. EV/sales was the only multiple with minimal variation, so I used this to estimate the total enterprise value of GE.

After multiplying the median, 1.875x by GE’s revenue of $83.928 billion for the trailing twelve months, I arrived at an EV of $157.365 billion. After subtracting debt, preferred shares and adding back cash we arrived at a price per share of $18.38.

The spread in implied price per share can be attributed to GE’s unique business model, and the fact that it has multiple different segments, making it difficult to find quality comparable companies. For this reason, I moved on to my discounted cash flow model. Some assumptions in the model are as follows.

1. EBITDA Margin will expand as GE cuts fixed costs (reduced fixed cost by $1B this year alone)
2. Depreciation and Amortization will lag reduced capex spending
3. As the company pays down debt, the capital structure will change and WACC will increase slightly
4. Terminal growth rate of 2% in line with inflation/GDP

After implementing these assumptions into my model, I arrived at an implied price per share of $6.94, well below GE’s current market price of $10.94. However, DCF valuations are extremely sensitive to the long-term growth rate used as well as the WACC. To show this, I performed a scenario analysis that yielded different share prices for different market conditions (see below). For a deeper look into all my valuation techniques please feel free to email me at [e-mail].

Out of all my valuation techniques, only the indirect valuation method yielded a share price higher than the current market price, albeit significantly higher. I believe share price for a company like GE is best valued based on the DCF as it is very difficult to find companies that have the same scale of operations and business climate that GE does. Additionally, multiples valuation uses the current market multiples and has nothing to do with the intrinsic value of the company. In my opinion the market is currently slightly over-bought and trading at higher multiples then we have seen previously. Keeping this in mind, my final weighting for each share price is shown below, leaving us with a final price target of $8.57.

Conclusion

Sell GE’s common equity because the market has not reacted sufficiently to the company specific headwinds it faces primarily in the power and capital segments (discussed earlier). Additionally, the growth segments; healthcare and renewable energy, will not gain market share if management is conservative with research and development spending. Lastly, renewables will continue to face significant margin pressure as technology advances and energy continues to become cheaper.