2 Conglomerate Stocks to Buy, 1 to Avoid

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

Conglomerates are difficult to invest in because one segment often struggles and overshadows the upside of a different, fast growing segment. Accordingly, the market can't properly allocate risks in a way that it can for more focused producers. With that said, diversification mitigates risk and is compelling if you are bullish on the economy. Below, I review 3 notable conglomerates.

General Electric (NYSE: GE) Is Still Worth Buying

While many continue to think of GE as an appliance and energy company, it is mostly a financial organization. The company will be reporting 3Q 2012 earnings soon, and I encourage investors to open a position sooner rather than later. GE Capital, which represents around a third of the business, is likely to report tailwinds in real estate. Perhaps most importantly, with a 3% dividend yield and a forecast for 12% annual EPS growth over the next 5 years, GE is safer than investors give it credit for.

Margins have also been on the increase despite how challenging the macro environment has been. Moreover, new management has more appropriately handled takeover activity by focusing on buying smaller businesses. At the same time, the company is planning to cut $1 billion in costs next year and $1.3 billion in the year after that. Investments in oil & gas, healthcare, and mining have helped diversify operations to mitigate risk.

As tough as the market has been, GE has also beaten expectations 4 out of the last 5 quarters (3Q 2011 was in-line). Greater leverage towards oil & gas will also position the firm to gain big on improved industrial activity. Healthcare returns in China have also offset weakness in Europe. I recommend buying to capitalize on this impressive growth story.

Tyco International (NYSE: TYC) Should Sell Off Assets, More Undervalued Than 3M (NYSE: MMM)

At a respective 15.5x and 13.7x past and forward earnings, 3M is quite cheap. It is also fairly safe, given the beta of 0.87 and 2.5% dividend yield. Analysts forecast 10.7% annual EPS growth over the next 5 years. Assuming expectations are met, 2016 EPS will come out to $9.37. At a multiple of 16x, the future value of the stock will be $150. Discounting backwards by 10% yields a present value of $93.14 - roughly in-line with the current market assessment.

Since organic growth prospects are fairly limited, the conglomerate has recently been in takeover mode. It recently announced that it will acquire Ceradyne, a ceramics producer, for $860 million. However, analysts have been rightfully reserved on the prospects of an integration. The target is focused more on highly speculative solar and nuclear energy and thus, in my view, will fail to capitalize on low natural gas prices.

3M also recently decided to terminate its proposed buyout of Avery Dennison. This makes me concerned about the extent to which management has been on the fence over past acquisitions. Why did they decide to abandon the takeover? What made it compelling two months ago but is no longer the case now?

Tyco is ultimately a much more attractive conglomerate pick. It trades at 10x past earnings, under book value, and at a PEG ratio of 0.74x. Accordingly, the parts could be sold to create value, and future growth is not being fully factored into the stock price. Based on this, I believe the firm could (and should) explore selling assets. The company is forecasted to grow EPS by 13.5% annually over the next 5 years, which is nearly 200 bps less than what was achieved in the past 5.

An acquisition can easily pay for itself. Free cash flow has, after all, dramatically reversed from -$1.6 billion in 2Q 2008 to $1.7 billion four years later. That is a 13.3% yield against market cap and comes with little leverage (the debt-to-equity ratio stands at 0.3x). Selling off assets will help the company raise a greater amount of cash to (1) lower borrowing costs and (2) make the capital allocation policy more shareholder friendly. Currently, of the conglomerates I've listed here Tyco offers the least compelling dividend distribution and shareholder repurchasing programs. Changing this will help win back risk-averse investors.

Foolish Bottom Line

For GE, the recent financial crisis struck a blow, but management took advantage of the market's dip to make strategic bets in energy. If you're a GE investor, you need to understand how these bets could drive this company to become the world's --infrastructure leader--. At the same time, you need to be aware of the threats to GE's portfolio. To help, The Motley Fool offers comprehensive coverage for investors in a premium report on General Electric, in which their Industrials analyst breaks down GE's multiple businesses. You'll find reasons to buy or sell GE, and you'll receive continuing updates as major events unfold during the year. To get started, click here now.

TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of General Electric Company. Motley Fool newsletter services recommend 3M Company. 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.If you have questions about this post or the Fool’s blog network, click here for information.

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