As a value investor, I aim to buy quality stocks at prices below their intrinsic worth, and sell when the City recognises this hidden value. The reverse is also true. I will avoid even excellent firms if they are overvalued.
General Electric (GE), tipped as a BUY by Merrill Lynch
So I was interested to hear Warren Buffett recently say in a TV interview that he felt “Jeff Immelt, CEO of General Electric (GE), was an outstanding leader… albeit he couldn’t help the hand that he’d been dealt”. The interviewer didn’t pick up on this, but it got me thinking about General Electric, the world’s third-largest corporation. After some detailed research and number crunching, here’s what I found.
General Electric is a huge, diversified group, organised into five main units. The first three are product-related: infrastructure (40% of its pre-tax profits), industrial (5%) and healthcare (10%). Together they sell a vast range of goods, including aircraft engines, trains, generators, turbines, nuclear reactors and medical-imaging equipment. General Electric also owns an 80% stake in NBC TV (10% of its pre-tax profits) and runs the monster General Electric Capital Services (35%), one of the world’s largest lenders. GE Capital Services not only has $639bn of assets under management funded mainly by $501bn of debt, but also offers loans to consumers and corporates in the form of credit-cards, car finance, equipment leases and residential and commercial mortgages.
Turnover and underlying earnings per share came in at $173bn and $2.20 in 2007, with 49% of the earnings generated by GE Capital Services due to the unit’s exceptionally low tax rate of 10%, compared with 22% for the rest of General Electric. This tax split is important; if GE Capital Services’ future profits were affected by the credit crunch, then to hit Wall Street’s targets the other units would need to generate disproportionately more profit to compensate for any shortfall. Moreover, I think there are minimal synergies across General Electric’s five units. To value this conglomerate, one needs to calculate its sum-of-the-parts. So what is each entity worth?
Undoubtedly the jewel in General Electric’s crown is its long-cycle infrastructure unit, which is expanding rapidly due to emerging market demand for new power stations, water treatment plants and aircraft engines. Assuming a 12 times operating profit (EBIT) multiple, infrastructure is worth about $130bn. I would value the smaller healthcare, NBC (80% share) and industrial operations at $35bn, $25bn and $15bn respectively.
The big unknown is GE Capital Services, which to me looks like a well-run bank. I would rate the lender on a multiple of 1.5 times book, or about $85bn. Barclays (worth $60bn) and Royal Bank of Scotland ($70bn) trade on corresponding price-to-book multiples of 1.25 and 0.8. By adding all five pieces together, a $290bn enterprise value ($29 per share) is derived for the whole group – or 20% less than today’s share price.
Lastly, the board is guiding it towards revenues and earnings per share of $195bn and $2.42 for 2008, putting the shares on a punchy p/e of 15. Given the acute risks associated with financial firms, together with the possible fallout from an economic slump on global infrastructure spend, I suggest you take profits. First-quarter results are due out on 11 April.
Recommendation: TAKE PROFITS at $38.27
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments