TSC 21: GE and the Capacity to Surprise - TheStreet

TSC 21: GE and the Capacity to Surprise

The onetime industrial standard-bearer was left out of the sector's rally. How come?
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If

General Electric

(GE) - Get Report

is the leader of industrial America, why didn't the company lead the brigade of upside surprises this earnings season?

The second-quarter reporting period has been a mixed bag so far, but an emerging theme is the better-than-expected results notched by many industrial companies, among them

Caterpillar

(CAT) - Get Report

,

3M

(MMM) - Get Report

and

United Technologies

. GE bucked the trend, however, posting earnings in line with expectations and tamping down expectations about the outlook for the rest of 2003.

The fact that the industrial conglomerate, considered by many to be a proxy for corporate America's outlook, has been a laggard recently raises some tough questions. Is the disappointment the economy's or is it GE's? If the latter, is it a matter of working through some near-term issues or signs that the company's great growth days are behind it?

"GE messed up by having guidance come down prior to the June 20 meeting, then guiding down again with the earnings report," noted one analyst. "That fishtailing doesn't make people feel good."

Despite the near-term uncertainty, several GE watchers say the nation's largest company (as measured by market capitalization) is making steady progress in its efforts to improve its operations, and looks poised to be a big beneficiary a little later in the economic recovery cycle. While the company probably can't return to the heady growth of the 1990s, the stock is no longer priced for it. And if shares dip further, they will start to resemble a strong buying opportunity for the longer term.

"Even though the earnings per share growth is somewhat slower, they really are hitting the trough now," said Jim Kelleher, analyst with Argus Research. "But when they finally pick up again, GE's stock will cycle up strongly."

Mitigating Factors

Earlier this month, GE posted second-quarter earnings of $3.79 billion, or 38 cents a share, down from $4.43 billion, or 44 cents a share, a year earlier. The results matched expectations, but GE narrowed the range of full-year profit estimates to $1.55 to $1.61, down from $1.55 to $1.70. This marks a growth rate of 3% to 7% over 2002.

There are plenty of factors contributing to GE bringing up the rear this earnings season, and a few of them put the company's earnings in a more positive light.

For starters, General Electric isn't getting a goose from the effects of a weak dollar that makes currency translations from overseas sales more favorable. "We hedge against currency effects," said GE spokesman David Frail. "Where foreign exchange did have an effect" -- such as constituting a few percentage points of the 8% growth in assets of its Commercial Finance business -- "the effect was by and large washed out by a similar impact on expenses."

A slew of big U.S. multinationals -- from

Ingersoll-Rand

(IR) - Get Report

and 3M to

IBM

(IBM) - Get Report

and

Coca-Cola

(KO) - Get Report

-- have noted that the weak dollar has inflated top-line and bottom-line results.

Another mitigating factor is that despite GE's operating challenges, the company isn't exactly getting up off the floor. Despite what is shaping up to be two years of single-digit earnings growth, GE's earnings per share have risen 13% on average over the past five years. Other industrial companies have seen their earnings contract over the past five years and are getting an earnings pop as business recovers a bit, analysts note. While the company isn't expected to maintain such high growth, analysts think GE will emerge with solid prospects.

"I don't think growth is going to be as robust as it was before, because it's pretty tough when you get this big in size to grow at 12% to 15%," said Chris Remo, equity analyst at MSB Fund, which holds the conglomerate in its portfolio. "But 10% is realistic, provided that you can turn around certain divisions."

The Troughs

The trouble-spot divisions are what is weighing most heavily on GE's earnings and prospects. Plastics, where earnings fell 71% during the second quarter amid higher energy prices and fierce competition, has been a major disappointment, but that division represents about 4% of overall sales. The bigger power systems and jet-engine businesses also have suffered mightily.

"Two of the big reasons GE didn't give any nice earnings surprises were that it had to put out a fire in its plastics division, and two of its three long-cycle businesses -- commercial jet engines and power turbines -- are just about in the trough of their cycles," said Argus Research's Kelleher.

The power systems business, which may represent as much as one-third of GE's business and was 2002's biggest business, saw profit fall 46% to $1.03 billion. "GE's turbines business was caught off-guard by

Enron's

blowup," Kelleher said.

Meantime, the jet-engine business has been hammered by weakness at the major airlines. Kelleher and others say the two businesses will likely bottom within the next year, if they haven't already. "They have really hit the trough, but they will pick up again strongly once they emerge," Kelleher said.

Aside from the operational issues, some GE watchers fret that the multifaceted company remains something of a "black box" when it comes to its balance sheet, and what shows up is cause for concern.

"This isn't your father's General Electric; they have increasingly relied on debt," said Hewitt Heiserman,

Real Money

columnist and founder of

EarningsPower.com. Heiserman notes that the company isn't a major credit risk, but he worries it "is using debt to overinvest in low-return businesses." Heiserman says the company should pay down debt and shrink some less-profitable businesses, "but it's hard when the institutional imperative is to get as big as you can."

Compression

Heiserman raised concerns about GE's financial-services business, which made up about 42% of second-quarter earnings. "Look at returns on finance business, they are pretty uninspiring," he said. GE apparently has, and has been looking to lighten up on some of its financial-services business.

Indeed, the increasing importance of GE's finance businesses -- coupled, of course, with the deteriorating business climate for key industrial businesses -- has been pinching the valuation Wall Street affords the company's stock. "You have a company that is 40% financial services. The market is giving it a price-to-earnings multiple that is a combination of what banks are and what industrial companies are," said MSB's Remo. "That helps explain the lower P/E."

GE apparently shares the concerns about businesses that offer lower margins and lower returns on equity, because it has begun making divestitures of slower-growth businesses, including some of its insurance assets. Many on Wall Street expect the asset sales to continue and help the company continue to emerge as a late-bloomer in this recovery cycle.

"We believe GE's current 8% to 9% long-term growth rate could move up to 10% to 11% over the next year or so as the company completes the divestiture of other slower-growing, lower-return businesses," said Prudential Securities' Nick Heymann in a recent report. Heymann rates the stock buy and has a 12-month target of $38 a share.

GE's stock, meanwhile, hovers at just above $28 -- and has lagged behind the broader market for much of the past year. GE's shares have risen 6.7% over the past 12 months ended Friday, compared with the

S&P 500's

19.1% return. Meanwhile, the stock's price-to-earnings multiple has been compressed to 18 times forward earnings -- compared with a five-year average of 32 and a peak of 51 times earnings in 1999.

Indeed, GE is now one of the few industrials currently trading at the low end of its historical valuation range. "We're not counting on it going back to 51, nor should anybody else," said MSB's Remo, "but you will see the market afford it a higher valuation when its businesses start to show real signs of recovery."

Meantime, many on Wall Street remain cautious about GE because of the company's lowered guidance. One analyst, on condition of anonymity, said some of the bearishness is from the many analysts who have been burned by GE's downturn the past three years.

"A lot of people got screwed because GE and a few of these stocks were supposed to be defensive and they weren't," the analyst said. "A lot of the cage-shaking may be about making the stock go down so they could get in, because they know eventually this thing's going back up."

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