Tuesday, July 20, 2010

"General Electric for the Long Run" (GE)

From Barron's Hot Research:

Hilliard Lyons argues that the industrial giant's stock will recover strongly in the next two to three years. 
General Electric (GE: NYSE)
By Hilliard Lyons ($15.25, July 16, 2010)
GENERAL ELECTRIC'S (TICKER: GE) second-quarter earnings exceeded consensus earnings-per-share estimates on strong financial results. The company's earnings-per-share from continuing operations of 30 cents rose 14% from 26 cents last year, and were ahead of consensus expectations of 27 cents. Industrial-operating margins increased due to favorable costs and restructuring benefits. All but one segment achieved higher profits. With 28% lower loss provisions, GE Capital reported positive-pretax income versus a loss last year. Financial earnings more than doubled in the quarter.

Revenue for the quarter declined 4%, and was below expectations. Total revenue of $37.4 billion compared to $39.1 billion last year. Industrial sales were down 6% to $24.4 billion due to lower-equipment sales. GE's services revenue was mixed but still provides a relatively stable, high-margin revenue stream. Financial revenue fell 2% to $13.1 billion, the result of downsizing of GE Capital Finance.
Order growth was positive, a good sign for future periods. Second-quarter orders of $19.2 billion rose 8% with equipment orders up 17% and service orders down 1%. Comparisons were relatively easy with a weak period last year, though orders exceeded the first-quarter level of $17.1 billion and the book-to-bill ratio moved above 1.0 for the quarter. The total backlog was nearly even at $172 billion.
Our 2010 EPS estimate is up five cents to $1.10 versus $1.03 in 2009. Previous restructuring could lower costs this year, aiding margins while lower financial loss provisions could boost financial earnings.
GE is rated Long-term Buy. We feel GE has strong upward earnings leverage in its industrial businesses as the global economy improves. We also believe this is the case with GE Capital as financial stresses ease. Our two-to-three year price target is $25 per share.

Second-quarter revenue from continuing operations declined 4% to $37.4 billion from $39.1 billion in the second quarter of 2009, and were below expectations. Industrial sales fell 6% to $24.4 billion, the result of lower-equipment sales. Services revenue was mixed among the various operating segments, but still provides a high margin buffer to weak equipment sales.

Revenue from GE Capital Finance fell 2% to $13.1 billion, with declines in commercial and real estate as downsizing of the unit continued. GE Capital assets declined 6% from a year ago to $588.0 billion. Pretax income from continuing operations increased 13% from last year despite lower revenue.
Industrial segment operating profit was about even in the quarter as margins benefited from favorable pricing and cost trends as well as from previous restructuring. Energy infrastructure operating earnings rose 3% but technology infrastructure declined 11% due to difficulties in aviation and rail. NBC Universal operating profit grew 13% and home and business solutions profit increased 59%.
Including corporate, nonfinancial-operating income rose 4% as corporate expenses declined. Earnings from GE Capital Finance more than doubled to $822 million even with a larger tax credit last year. GE Capital reported a pretax profit of $721 million versus a pretax loss last year. Loss provisions of $2.01 billion were down 28% from $2.82 billion last year. Adjusted for an accounting change, reserves were down slightly on an absolute basis but coverage improved due to reduced assets. Parent company interest expense rose 24%.
Net income rose 14% on a slightly lower overall tax rate. The industrial-tax rate was above last year, but the jump in GE Capital profit lowered the effective rate. EPS of 30 cents from continuing operations after preferred dividends increased 14% from 26 cents a year earlier and exceeded consensus expectations of 27 cents.
So far, 2010 appears to be unfolding about as expected with improvement in GE Capital but some weakness in the industrial areas. Like many companies, GE is experiencing margin improvement on continued-soft revenue, though rising order rates could result in higher sales in upcoming quarters. In all, we feel the underlying business performed relatively well and the order growth was encouraging.

We feel that GE's infrastructure businesses are poised for long-term growth. The large energy unit is positioned to benefit from long-term global demand for energy production and for alternatives to fossil fuel generation in light of concerns about global warming. Despite near-term weakness, aviation and rail should experience growing shipments over the long-term and could continue to build revenue in China, India and other emerging markets once the global-economy rebounds. In addition to this, we feel GE has successfully built its model of obtaining service agreements on its large installed base of equipment, generating high-margin service revenue which has helped support industrial results in a difficult environment and contributed positively to margins.
The restructuring of GE's ownership in NBC Universal appears to be a long-term positive. GE's plans call for a downsized financial operation with at least 60% of earnings coming from industrial units and about 40% or less from the financial area. Despite current difficulties, commercial finance will likely have a role in the company going forward with synergies in various industrial areas.

Based on estimated 2010 EPS, GE stock is trading at a value similar to the Standard & Poor's 500, and we note this is on what we would consider depressed earnings. We would argue for a premium ultimately for GE's world class, industrial businesses which are typically market leaders, its global diversity, relatively high returns, and a still strong credit rating, as well as the potential for improvement.

--Stephen A. O'Neil

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