GE's Growth Looks Short-Circuited

General Electric is probably the economy's single-best corporate proxy. That's why it's in TheStreet.com 21, a new index of 21 companies designed to be a leading indicator of the economy's direction for the rest of the year and beyond. Click here for an introduction to the TheStreet.com 21, and here for a chart listing the components and their reason for inclusion.)

With General Electric (GE - commentary - Cramer's Take) down 50% from its all-time high and talk of an economic recovery, is now the right time to buy a big slug of this industrial/financial concern?

If you're a long-term, cautiously greedy investor, the answer is "no." Here's why: First, GE's earnings power is mixed; second, its yield on incremental investment is poor; and third, there's too much debt as a percentage of tangible book value.

Earnings Power Is Mixed

As we see in the first chart, GE was profitable on a GAAP/accrual basis every year for the five years ended Dec. 31, 2002. The firm also was profitable on an enterprising basis; i.e., its return on capital was greater than the cost of capital. Of concern, however, are the defensive losses; i.e., negative free cash flow.

One reason GE has defensive losses is its huge investment in fixed capital. In 2002, for example, management invested $38 billion in buildings, real estate, machinery and acquisitions. This results in a use of cash not captured dollar-for-dollar in the year incurred in the other two income statements.

GE also is making a huge investment in working capital -- $35 billion last year. That means current assets like receivables and inventory are growing faster than current liabilities like payables and accrued expenses. This, too, is an indirect charge in the accrual and enterprising ledgers.

The combination of defensive losses and enterprising profits means GE is situated in the Earnings Power Chart's lower-right box. Ideally, the Fairfield, Conn.-based company would be in the upper-right box and continuing to move in an upper-right direction -- what I call an Earnings Power Staircase company. When a company forges a Staircase, that's the hallmark of a great growth stock.

(Many companies actually have two types of investment in fixed and working capital: maintenance and discretionary. As a result, some analysts add back to defensive profits (losses) the discretionary portion, reasoning that, in a pinch, management can cut back on these "growth-producing initiatives" and instead use the extra funds to service debt, repay loan principal, etc. If you use one income statement, this adjustment makes sense. However, in a dual income statement approach, I prefer to be extra cautious and expense all investment in the defensive model. For one thing, outlays for capital spending and working capital increases are uses of cash. Also, you never know which investments will pay off and which will be duds.)

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Hewitt Heiserman has been a financial analyst for 15 years and has worked for Fidelity Investments, Simplex Time Recorder, American Holdco and Breakaway Solutions. He is now writing a book on the Earnings Power Box, an analytical model he created to gauge the quality of a firm's profits. (The Earnings Power Box is a trademark of Hewitt Heiserman.) At the time of publication, Heiserman was long GE via mutual fund holdings, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Heiserman appreciates your feedback and invites you to send it to [e-mail].