There’s something to be said about a company that can handle just about anything thrown at it.
Since the founding of the Dow Jones Industrial Average (DIA) just before the turn of the 20th century, the composition of the 30 stock index has changed more than 50 times. There’s one company, however, that has retained its relevance in the broad market benchmark the longest. That company is General Electric (GE), which has been a staple of the DJIA since 1907, well over a century now. For long-term investors, there’s no better example of a company that has handled just about every market cycle than the industrial giant.
In recent years, General Electric has been working to shake off the stigma related to “overextended” financials exposure attained during much of the “Jack-Welch” era, a move that came back to haunt the company during the Financial Crisis of 2008-2009, which forced the conglomerate to cut its dividend. Some income investors felt betrayed in light of the move to slash the payout and may never come back to shares (no matter what), but we think the “new” General Electric has learned from its recent “troubled” past. From where we stand, its future is bright, even after considering some of challenges exposed during fourth-quarter results, released January 22.
For starters, we continue to applaud the executive team’s refocus on its high-return, defensible industrial operations, now expected to account for 90% of earnings by 2018 (was 58% in 2014). The spinoff of Synchrony Financial (SYF) and its Retail Finance businesses were nice steps toward de-risking its consolidated portfolio, and management noted that it has divested $150+ billion in financials assets thus far, paving the way for “de-designation” as a SIFI, or “systematically important financial institution” (i.e. too big to fail). Not only will ditching nearly all of its financials exposure remove financial “contagion” risk, thereby reducing its cost of capital (project hurdle rates), and a hefty regulatory burden, but it will also increase flexibility to drive better returns across the remainder of its portfolio. The “GE Capital exit plan” is expected to be largely complete by the end of 2016.
Still, portfolio acquisitions from Alstom’s Power & Grid business to Halliburton’s (HAL) drilling assets and pending portfolio divestitures including its ‘Appliance’ business to China’s Qingdao Haier will continue to “muddy” GE’s proforma financials, but we did like the company’s target it released in December for 2016 “operating earnings” to rise to $1.45-$1.55 per share, up from its 2015 per-share of $1.31 number in 2015, to be propelled by as much as a 15% expected jump in operating income. GE remains on track to return more than $90 billion to investors from 2015 to 2018 and is targeting a return of ~$26 billion to shareholders in 2016 (~$8 billion dividend; $18 billion buyback), down from ~$33 billion in 2015 but still a very robust figure. The company reaffirmed these targets when its released fourth-quarter results.
That said, GE’s fourth-quarter 2015 results could have been a lot better, and we’re growing less and less comfortable with the presentation of its financials. Industrial segment organic revenue dropped modestly on a year-over-year basis in the quarter as its ‘Renewable Energy’ and ‘Oil & Gas’ segments weighed on performance, but its ‘Healthcare’ segment and its soon-to-be-divested ‘Appliances’ division also contributed to the decline. GE’s ‘Power,’ ‘Energy Management,’ ‘Aviation,’ and ‘Transportation’ segments helped offset the organic top-line weakness to a degree, but overall industrial segment operating profit also faced pressure during the quarter, something we would have expected better cost management and higher margins to counteract.
Further, management continues to headline the rather unusual term, ‘GE industrial operating + verticals EPS,’ and while we like the incremental disclosure, the numbers are starting to drift materially away from core and much more dependable GAAP performance. In the fourth quarter of 2015, for example, ‘GE industrial operating + verticals EPS’ came in at $0.52 per share, up 27%, while GAAP earnings per share from continuing operations dropped 26%. We don’t like the discrepancy, and we believe GE will only get rewarded for its portfolio retransformation when the latter GAAP earnings per share from continuing operations shows material improvement to defend its valuation. The large drop in the measure in the fourth quarter is not exactly encouraging, though we note results continue to be “messy” given recent portfolio transactions.
On a positive note, however, General Electric generated $16.4 billion in cash flow from operating assets in 2015, up 8%, as it drove total industrial and industrial segment margins higher 110 basis points and 80 basis points, respectively. The company’s orders grew 3% (1% organically) on a year-over-year basis in the fourth quarter ($13.8 billion versus $13.1 billion), and its backlog grew to an impressive $315 billion (up from $266 billion and +7% organically), though we note some of the incremental expansion includes a contribution from Alstom. During the period, its ‘Power’ segment generated organic orders growth of 29%, it landed its largest-ever deal in India in its ‘Transportation segment,’ it won a $600+ million services contract with Cheniere (LNG), and it landed $17 billion in new business from the Dubai airshow. ‘Life Sciences’ and ‘Bioprocessing’ continue to be strong areas with its ‘Healthcare” division.
Looking ahead to 2016, General Electric is expecting 2%-4% organic revenue growth thanks to a strong backlog and despite a very difficult oil and gas market. Though GE may hit that pace of top-line expansion, we’re paying the most attention to operating profit growth, free-cash-flow performance ($29-$32 billion target for 2016), and the firm’s ability to execute on cost-cutting initiatives. We’d like to see better operating EPS performance in the GAAP representation of results, and we’re looking forward to a much “cleaner” balance sheet once the company completes its financials divestitures. We didn’t think GE’s fourth-quarter performance was great, but we’re willing to get paid a lofty dividend yield (~3.3%) to wait for “cleaner” financials when the time comes. Our fair value estimate remains $30+.