At the time of writing this article, the S&P 500 is sitting just a tad above 2,000 points. This after a five-year run that has seen the index up almost 100%. Think about that: The index almost doubled itself in just five short years. Is that collection of 500 stocks now worth twice what they were in late 2009?
Warren Buffett was eternally correct in asserting that price is what you pay, while value is what you get.
As such, I’m sticking to my long-term plan whereby I invest excess capital generated from savings on a monthly basis into high-quality businesses that regularly and reliably pay and raise dividends. The S&P 500 could go to 4,000 points tomorrow, and it doesn’t change my plan. As long as I can still continue to find individual businesses that are fundamentally sound and attractively valued I’ll continue to allocate available capital to dividend growth stocks.
So here we go! Another addition.
I purchased 40 shares of General Electric Company (GE) on 9/4/14 for $25.91 per share.
Overview
General Electric is a diversified conglomerate with products and services that range from energy infrastructure, finance, power generation, aircraft engines, medical imaging, and household appliances.
The company operates in eight segments: GE Capital (30.2% of fiscal year 2013 revenue); Power & Water (16.9%); Aviation (15%); Healthcare (12.5%); Oil & Gas (11.6%); Appliances & Lighting (5.7%); Energy Management (5.2%); and Transportation (4%).
Approximately 47% of 2013 revenue was generated from US sales.
Fundamentals
GE has had a rough decade, both in terms of the business and the stock.
The stock had a catastrophic drop during the height of the economic crisis, as GE was heavily exposed to the financial issues that were plaguing the economy at the time. As such, shareholders saw the stock drop from ~$41 per share to ~$7 from late 2007 to early 2009. On top of that, the dividend was cut from $0.31 quarterly per share to $0.10.
While it’s no consolation to shareholders during that time, the core business has been steadily improving over the last few years. However, growth over the last decade isn’t particularly appealing.
Let’s take a look. Their fiscal year ends December 31.
Revenue shrank from $152.363 billion in FY 2004 to $145.715 billion in FY 2013. That’s a compound annual growth rate of -0.49%, as in negative.
Earnings per share paints a similar picture, as it also shrank over the last decade. EPS came in at $1.59 in FY 2004, and finished at $1.47 for 2013. That’s a CAGR of -0.87%. However, we don’t skate to where the puck has been, and similarly so we can’t invest where a business was. The last five years of EPS growth has been much more favorable, showing a CAGR of 9.3%. Meanwhile, S&P Capital IQ predicts EPS to grow at a compound annual rate of 7% over the next three years.
Dividend growth over the last decade hasn’t been particularly strong either, due to the aforementioned dividend cut. However, after cutting the dividend in 2009, the company has been committed to growing it, and has raised it six times since to the current $0.22 quarterly per share payout. I think it’s a good bet the company will continue growing the dividend from here. They specifically spell out growing the dividend as a priority, so it really all depends on business execution and the broader economy.
GE continues to send out a ton of cash to shareholders, though. They returned $18.2 billion to shareholders in 2013 alone, via dividends and buybacks. They’ve been steadily reducing their massive share count after peaking in 2010 at over 10.6 billion shares. The company aims to reduce the share count by 10% between 2012 and 2015, which I think is realistic. That would put the company at about 9.5 billion shares.
The yield on shares stands at an attractive 3.39%, with a payout ratio of 60.3%. The payout ratio is moderately high, but I think the company will continue expanding EPS to allow for the dividend to continue growing in the high single digits.
The balance sheet continues to improve, but is still heavily leveraged. GE had over $221 billion in long-term debt, as of the end of 2013, against total cash of just over $132.5 billion. So these are obviously huge numbers we’re talking about.
The long-term debt/equity ratio stood at 1.7 at the end of 2013, which is down significantly from years past. And the interest coverage ratio is 2.6, meaning the company can pay interest expenses 2.6 times over with earnings before interest and taxes. These aren’t the type of rock solid numbers I usually look for, but GE has a lot of potential to shore the balance sheet up. All of these numbers are massive improvements on what was there just five years ago.
Profitability appears solid, though margins are still improving as well. Net margin has averaged 9.1% over the last five years. Meanwhile, return on equity has averaged 11.41% over the same time frame.
Qualitative Aspects
I usually would never touch a business with metrics that look like the above, but GE is a unique case. It’s currently a healthy and growing business that made some mistakes in the past that kind of came up and bit them. These mistakes were primarily based around relying too heavily on the finance division and exposing that division to too much risk, as well as diversifying away from what the business really is.
However, GE has been shedding off non-core businesses since the crisis, some of which were quite sizable. For instance, the company sold its NBCUniversal business to Comcast Corporation (CMCSA) in two chunks (selling off the remaining 49% in 2013 for $16.7 billion) and is in the midst of spinning off its retail financing business through an already completed IPO that resulted in an independent company:Synchrony Financial (SYF). GE floated approximately 20% of the business via an IPO, while the remaining ~80% will be spun off to shareholders in 2015 via a share swap. This spin off will allow GE to pay down debt and buy back a considerable number of shares via share reduction in the swap. Finally, they are in discussions to sell off the appliance division due to low margins, which, if completed, will help with GE’s goal of increasing their margins.
And while shedding non-core businesses, GE has focused on the industrial side of the house. They are acquiring the power and grid businesses of French company Alstom S.A. for $17 billion after a very public battle, and expanding their footprint across energy, infrastructure, and aviation. Their backlog has been steadily rising over the last year, and it stood at a whopping $246 billion at the end of the second quarter. I believe that represents strong demand for GE’s solutions and a healthier worldwide economy. That should continue to keep them busy in their core competencies.
GE is making big bets on infrastructure, citing a need for $60 trillion in worldwide infrastructure investment by 2030. They continue to position themselves well with product offerings in energy management, power generation, and transportation. They are growing in areas where energy is abundant, but getting it to people is hampered by insufficient infrastructure, technology, and investment. They cite 30% annual growth in areas like Africa due to this.
They have wide product diversification, breadth, and scale that is unmatched. It’s not like any ol’ business can just start cranking out jet engines, locomotives, gas turbines, and deepwater drilling systems.
This gives them inherent competitive advantages, but execution will determine how much GE grows from here. But I do believe management is making the right moves by jettisoning businesses that aren’t part of GE’s core industrial competency and focusing on businesses that are. Redeploying assets, personnel, focus, and capital takes time in a ~$260 billion company, but I think the foundation has been laid for a very successful future.
Risks
Many of their businesses are cyclical, which can lead to erratic financial metrics. Furthermore, they still have significant exposure to the financial sector via GE Financial. That carries regulatory and financial risk. In addition, many of the businesses and markets that GE competes in are extremely competitive. Finally, there are larger macroeconomic risks, as many of GE’s projects are quite large and require significant broader economic growth.
Valuation
GE shares trade hands at a price-to-earnings ratio of 17.76, which is higher than its five-year average of 15.9. However, the last five years have been clouded somewhat by both a rising stock market and internal business changes. Going back even further, it appears GE shares would often trade at P/E ratios of 20 or above, which may reoccur as the business improves.
I valued shares using a dividend discount model analysis with a 10% discount rate and a 7% long-term growth rate. I think GE can grow the dividend at this level, provided earnings grow in likewise fashion, which will require proper execution. Furthermore, this rate is below the growth rate in EPS and the dividend over the last five years, while in line with the predicted growth rate looking out over the foreseeable future. The DDM analysis gives me a fair value on shares of $31.39. I believe that allows for a margin of safety, since shares are trading about 20% lower than this.
Conclusion
GE has scale, breadth, and diversification that is pretty much unrivaled. They have been making great strides to improve the business by focusing on the core industrial segments, jettisoning businesses that take away from their competencies and can potentially do more harm than good. The balance sheet and margins have both been steadily improving, while earnings and the dividend have been growing at robust rates since the depths of the financial crisis. Energy, infrastructure, and transportation are all big plays on a growing economy across the globe, and GE’s massive backlog proves that they’re making the right moves here.
This purchase adds $35.20 to my annual dividend income based on the current quarterly payout of $0.22 per share.
My portfolio still holds 49 positions, as this was an addition to an existing investment.
I’m going to include current analyst valuation opinions below, as I use these to concentrate my reasonable valuation estimate:
Morningstar rates GE as a 3/5 star value, with a fair value estimate of $29.00.
S&P Capital IQ rates GE as a 4/5 star buy, with a fair value calculation of $27.00.
I’ll update my Freedom Fund in early October to reflect this recent purchase.
Full Disclosure: Long GE.
What are your thoughts? Think GE is a buy here?
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