Should You Buy This Dog of the Dow?

Masam is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The nation’s largest conglomerate, General Electric (NYSE: GE) reported today. The company topped both revenue and EPS estimates. Given that the company acts as a barometer for the economy, this has sent bullish signals to the market. The company expects solid growth for its industrial businesses in 2013. However, there are macro headwinds as well, which means that the growth might not come at all. Who are the investors supposed to believe: the bulls or the bears?

Understanding General Electric’s Operations

GE made the following proportions of revenue from each of its segment:

 

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For quite some time, the bulls have been chanting that GE expects a solid improvement in the margins of its industrial businesses. Let’s see how each segment performed in the last quarter:

Power & Water saw a modest revenue growth as wind (sub-segment) sales begin to lap tougher comps and gas service shut downs were pushed to the right. The demand for the energy services is growing, but high utilization rates for the US gas turbines are delaying outage cycles. However, it means a strong 2013/2014 given that sales are being pushed ahead. The margins in the quarter saw a decline of 40 basis points due to the sell through of low-priced backlog and negative mix from wind.

Oil & Gas (O&G) –Top-line growth and operating margin expansion was driven by continued secular trends such as expanded production capacity, aging pipelines, and growth in unconventionals (LNG) & subsea. O&G should continue to expand internationally especially in the emerging markets. New product development is also a key driver as O&G invests ~3%-4% of its revenues into technology R&D each year.

Energy Management (EM) – It is a $7.5 billion business with 1%-2% operating margins. The newly split-out EM segment is a key area of focus for improvement. GE believes EM should be a 10% margin business; (peers are at 10%-15%). For the quarter, it posted a margin of 2%. The fixed cost reduction opportunities (revamping IT infrastructure, SKU reduction, footprint reduction) will add few points to the margin. Also, a positive service mix will also add another few points in the future. This business should now benefit from stand-alone status and transparency/accountability that comes with the new reporting structure. It is also worth noting that Intelligent Platforms (GE’s automation-linked business with $750 million in sales and ~8% margins) will also now be included in EM (was in HB&S prior to that).

Aviation – This segment experienced top line growth of 6%. The revenue growth rate has accelerated from the last quarter as GEnx engine shipments ramp up and spares lap easier comps. The margin of 18.7% came out strong (but was below the expected 19.7%), and should continue to grow from here as Aviation begins to see positive leverage on R&D spend and company moves up the learning curve on the GEnx shipments. On the equipment side, the book/bill of 1.2 was larger than the 1.09 ratio posted in the last quarter.

Healthcare was a little light of expectations last quarter with weaker than expected US offsetting continued strong EM growth. The commentary throughout the quarter was encouraging, and DHR’s positive pre-release and commentary at a conference on Wednesday had already given bullish signals to the market. Therefore, a rise of 50 bps in the margin (due to the restructuring) was not a big surprise for the market. Though the revenue for the segment increased by 1% only (YoY), I believe that the outlook is improving and I see a bright future for this segment.

Transportation – This segment saw a revenue growth of 15% (much higher than the expected growth of 5%). However, the revenue fell by 7% in the fourth quarter on a YoY basis. Locomotives have begun to hit tougher comps. The margins continued to show significant improvement y/y due to fixed cost absorption (an improvement of 290 bps was seen).

Caterpillar (NYSE: CAT) is becoming a real competitor here, but it is considered very rational on price and focused on margins in this business. Changing emissions standards in the US in 2015 and strong demand internationally should help drive continued improving performance for both companies. For a long time GE has been a leader in this industry. Earlier on, it easily outsold to its main locomotive rival, Electro-motive diesel. Now Caterpillar is also having a tough time catching up with GE’s sales. However, another important aspect is that GE’s earnings beat today has made me believe that Caterpillar might also have a good earning release to announce given that both GE and Caterpillar are considered to be economic bellwethers.  

At this point, GE’s Mining segment should also be discussed. Many people felt that GE would acquire the mining manufacturer Joy Global (NYSE: JOY) to penetrate quickly into the mining market. They felt that way because of Joy’s attractive margins and cheap valuations. Also, given that GE sold its engines to Joy that were fitted in its electric shovels, this acquisition made a lot of sense. However, GE has reiterated its intention to grow organically and is not looking to do big acquisitions in this space.

Home & Business Solutions (H & BS) – The pricing competition in appliances and material inflation is keeping margins depressed. The appliance sales improved with US residential starts (up 9% last quarter), but the lighting business continued to be impacted by a weak Europe. As already stated, Intelligent Platforms will now be reported in the Energy Management segment.

GE Capital - Operations in the quarter for GECC continued to improve but at a slower pace than prior quarters. GECC showed a net income of $1.8 billion, up 9% y/y and representing 27% of total GE earnings (down from 44% last quarter). The Real Estate earnings were a huge surprise as they rose from $217 million last quarter to $309 million in this quarter. Looking forward, the GECC balance sheet is shrinking faster than expected and the company plans to shrink it further in 2013. Long-term focus will likely be on middle market lending & leasing going forward as ROIs are continuing to grow.

Conclusion

GE pays a solid dividend yield of 3.6%. The stock has underperformed significantly since last earnings, down 7% in the last 3 months vs. the XLI, which is up 6%. I believe this has been an over-reaction given a continuity of the energy cycle thesis, resolution of tax risks, strength of banking stocks, positive healthcare data points, and evidence of re-accelerating macro. GE appears well positioned to outgrow peers in 2013 given business mix and visibility within the backlog.


AnalystX has no position in any stocks mentioned. The Motley Fool owns shares of General Electric Company and Joy Global. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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