GE’s shares have been out of favor and, in our opinion, are an unusually attractive opportunity to earn a high return over the next few years without large risks of permanent loss. About 19% of the company’s revenues are from China and other emerging countries. These sales are growing at a 20+% rate and alone are contributing 4+% to the company’s revenue growth rate. Several other parts of the company also are growing rapidly (wind turbines, water purification systems, medical imaging diagnostic systems, asset based lending) – and, all-in-all, we would expect that the company’s revenues will grow at a 10% rate. Earnings should grow faster than revenues, partially because of mix (higher margined products and services are growing faster than lower margined ones) and partially because the company’s SG&A as a percentage of revenues is declining due to cost controls and leverage over fixed costs. Our model shows that GE’s pre-tax income will grow at a 12.5-13% rate. Over the past few years, GE has benefited from an unusually low effective tax rate, largely because a large percentage of revenues and profits come from low tax rate countries, such as Ireland, where the corporate tax rate is 12.5%. We project that the company’s effective tax rate will increase from 15.5% last year to 23.5% in 2010 (I note that this is a conservative estimate that the company does not agree with; management believes that its tax rate will increase some, but will remain somewhat under 20%). Assuming a 23.5% effective tax rate, our projections show GE’s net earnings growing at a 9+% annual rate over the 2007-2010 period. GE generates large quantities of excess cash flow, some of which is used to purchase shares. The number of shares outstanding has been declining at about a 1.5% annual rate – and we expect this to continue. Therefore, we would expect that GE’s EPS will grow, over a several year period, at a 10.5+% average annual rate. Our single-point projection is that GEs EPS will increase from $2.20 per share in 2007 to $3.00 per share in 2010.
We value GE as follows.
1. In 2010, about 40% of after-tax profits will come from the “Infrastructure” segment, which sells jet engines, wind turbines, power generating units, water purification systems, locomotives, etc. The segment’s products generally have leadership positions. The demand for the products is growing at a 15% rate – and this is expected to continue for at least the next several years. The segment is a gem – among the best industrial businesses in the world. Given its quality and growth rate, we believe that it is worth 25-30X earnings.
2. About 9% of profits come from the “Healthcare” segment, which, among other products, sells imaging diagnostic equipment. The segment’s products and information technology services are highly regarded and are expected to enjoy revenue growth of about 10%. We value the segment at about 20X earnings.
3. The “Industrial” segment is projected to account for about 4% of GE’s total profits. Two of the segment’s major product lines are light bulbs and household appliances (the appliance business might be sold). This is a slow growing segment that we value at about 12.5X earnings.
4. NBC-Universal is expected to account for about 8% of total corporate earnings. Most of the earnings and growth in this segment comes from cable TV, where GE has a strong position, including CNBC. We value NBC-Universal at 15-17.5X earnings.
5. GE Money is expected to account for about 12% of earnings, pro forma the sale of the U.S. third party credit card business. A large part of GE Money’s continuing businesses will be consumer financing in emerging countries, where growth and margins are relatively high. We value the business at 12.5X earnings.
6. In our opinion, the “Commercial Finance” segment, which is expected to account for about 27% of GE’s 2010 profits, is a particularly well positioned business that should grow rapidly and enjoy expanding margins. While Commercial Finance does own some commercial real estate (real estate has been a solid business for GE), the segment’s main activity is asset based lending. GE has several key and lasting advantages in asset based lending: (1) the company’s AAA credit rating gives it access to inexpensive capital; (2) it enjoys efficiencies of scale; and (3) because it manufactures many of the assets it leases, it has important knowledge advantages when assessing credit risks and when re-marketing or selling equipment that is coming off leases. Furthermore, at the present time, because of the current credit crunch, many of GE’s competitors have pulled back from the business. Thus, GE is seeing more business than it can accept – and the reduced competition has led to particularly favorable spreads. For all these reasons, we believe that “Commercial Finance” is a gem of a business that is worth at least 20X earnings.
Based on the above valuations for each of GE’s six segments, the entire company would be worth 20.5-23X earnings. I note that, over the 12 year period 1996-2007, GE’s shares sold at an average PE ratio of 22+X. While some on Wall Street criticize GE for being a conglomerate with a large finance subsidiary, few seem to criticize Berkshire Hathaway for being a conglomerate with large financial operations. In fact, I would much prefer GE’s manufacturing businesses to Berkshire’s and GE’s Commercial Finance to General Re and GEICO, which, although well run, have few lasting competitive advantages in highly competitive, commodity lines of insurance.
In summary, two years from now, we believe that GE will be worth in excess of $60 per share. If the shares do sell at this level, an investor purchasing the shares today would approximately double his or her money, including a dividend yield of close to 4%. There have been few times in my investing career when I have been able to purchase such a high quality company that offers large upside potential and, because of its quality and price, substantial protection against permanent loss.
GE's shares have been out of favor, partially because Q1 earnings dissapointed Wall Street, largely due to non-recurring items. We expect that the company's earnings growth will be strong over the next few years, even if economic growth in the U.S. and Europe is lackluster, and that the shares eventually will rebound strongly to a level that more adequately reflects their value.