Conglomerate Round: 2 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.

If you are just confident on the long-term macro trends and believe that the bears are over their heads, you may want to consider buying conglomerates. Although an extensive analysis would require a sum-of-parts analysis, sometimes it is helpful to look at the wider outlook of the business overall. With conglomerates, I recommend buying based on compelling multiples and how well the company is targeting positive secular trends, since they are often too complex for the market to ever fairly value (and hence the shift towards breakups). I review 3 conglomerates below with this intent in mind.

Why General Electric (NYSE: GE) Is A Long-Term "Buy"

At only 15.7x forward earnings and a 3.2% dividend yield, General Electric trades at a compelling price. In mid-October, Deutsche Bank initiated a "buy" with a $26 price target, which is at around a 20 - 25% discount to the current market assessment. 11 of 14 analysts call the diversified tech and financial "buy." Even though free cash flow has trended significantly downwards from $34.6 billion in 2Q10 (ttm) to just $21.2 billion today, the yield is still an impressive 10%.

There are several catalysts / growth drivers General Electric has going for it. In energy, I like the company's interest in natural gas development, which has been evidenced by the addition of 115 new jobs and facility upgrades. The firm has also become something of an investing conglomerate, and I believe this will pay off big given the company's large cash holdings and connections. It intends on spending upwards of $100 million in just venture capital investment and has been particularly bullish on Internet trends.

These investments are specifically geared towards helping clients use systems more efficiently--an offering that will help catalyze the $42 billion services segment. GE believes that "an industrial Internet" could add as much as $15 trillion to global GDP and cut out $150 billion in corporate waste. To put this into perspective, if global GDP growth came exclusively from this "industrial Internet," it would be growing at a rate of 1.1%--a third of the average growth during the last three decades.

I'm not so sure about the whole concept behind "an industrial Internet," but I like the interest in cutting expenses across corporations. The demand for ever-improving efficiency is deeply rooted in shareholder interests. The company believes that its new sensor technology will enable hospitals to see 10,000 more patients each year. The installation of its 20,000th wind turbine in mid-November is yet another instance where management is positioning itself for the long-term future.

Avoid 3M (NYSE: MMM)

I am not nearly as enthusiastic about 3M, which trades at 14.6x past earnings and is coming off of a slow growth trajectory. The diversified technology company may have a return on invested capital of 20.7% but has a poor outlook on the Street for a reason. Of the 16 reporting analysts, 11 rate the stock merely a "hold." Only 6.7% annual EPS growth is forecasted over the next 5 years is forecasted, so multiples would have to expand to justify calling the company "undervalued."

There are several factors to really look at.  First, the company has been successful in R&D. Over the past 5 years, R&D has gone up 16.6% to $1.6 billion while free cash flow has gone up by 32% to $3.9 billion. It is therefore a good idea that management decided to increase annual R&D spend to 6% of revenue. But, bear in mind, the economy was just starting to recover, so an average growth rate of 6.4% free cash cash isn't incredible.

Second, the company has started to focus on inorganic ways to catalyze the business. Just a few days ago, 3M announced that it closed the acquisition of Ceradyne. It earlier had to give up its hunt for the office & consumer products business of Avery Dennison after unsuccessful negotiations.

Third, management is setting aggressive targets, such as above a 20% return on invested capital, and as high as a 11% EPS growth rate. In mid-September, management had to admit that its initial target of 7 - 9% top-line growth was now a "stretch" in light of an uncertain macro environment. So, again, the focus has been on M&A.

As 3M struggles to balance its dueling interests in takeovers and organic R&D innovation, there are other conglomerates, like GE, that are undervalued and attractive right now. Though free cash flow has stayed relatively steady during the last three years, it is now yielding a terrific 16%. At 2.6x book value, the company is also cheaper than its peers. For this reason, I believe it could possibly be broken up to unlock value through better enabling investors to allocate risk into different segments. A few weeks ago, FBR Capital released an "outperform" rating with a $35 price target. Accordingly, there is plenty of value to be unlocked.


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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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