GE still offers value even after 64% rally

Posted by Dan Hung

April 6, 2009

As with the rest of the market, GE’s stock has rallied significantly off its March closing low ($6.66, 3/5/09). Maybe more comforting, the stock’s now seems to have firmly developed support above $10 per share. While not significant from a fundamental stand point. $10 stocks are sometimes a key threshold for certain mutual funds or a significant psychological threshold for many retail investors. I mentioned in a previous post about GE’s good fortune after surprisingly poor headlines (a dividend cut and the loss of its sterling credit rating) that the stock may no longer be within the risk tolerance of its traditional investor base – conservative, income oriented investors. GE’s stock, however, should be very compelling to a new set of investors – value investors.

Crude GE Cash Flow Valuation
GE Cash Flow from Operating Activities was reported as $19.1 billion in 2008. This includes $2.4 billion dividend from GECS which we can conservatively assume will be zero in 2009. This would imply that cash generated from its “traditional” businesses – infrastructure, consumer & industrial, and NBC universal – was $16.7 billion in 2008. Net capex in 2008 was $5.0 billion down from an average of approximately $9 billion in 2007 and 2006. Crudely speaking, GE ex-GECC had $11.7 billion of free cash flow in 2008.

With no growth and a 10% discount rate, this implies $117.0 billion in value. GE ex-GECC carries only $13.2 billion in debt leaving $103.8 billion in value for equity. GE’s current market cap $115.53 billion @ $10.94 per share. Does this mean GE is fairly valued or maybe even slightly over valued? Maybe. Maybe not. Let’s not forget that this crude valuation assumes that the non-GECC business will never grow again AND that the Company will never receive value from the GE Capital business ever again. The flip side of this argument is that there remains some risk that GECC will parasitically poach cash flow from GE’s core business for several years in order to service its significant debt burden ($193.7 billion in debt). The Company did, however, announce 90% of its 2009 long term debt needs were financed, ostensibly the most difficult year for the Company to raise funds.

Some may also point out that GE’s infrastructure and NBC units are not likely to repeat their 2008 performance in 2009. Do not forget, however, that a cash flow valuation relies not on short term performance, but long term performance. Using a more representative model, we could assume that GE’s cash flow will decline in 2009 and then return to a growth rate more in line with GDP, very conservatively 2%. To target the $117 billion rate, GE’s cash flow could fall to $9.6 billion in 2009, or 18% from 2008′s level.

A Confirmation Valuation
I’ll admit, the discounted cash flow used above is rather crude. As such, let’s use another valuation methodology and try to confirm the conclusions above. We’ll break GE’s non financial businesses into three segments – infrastructure, consumer & industrial, and NBC.

The GE Infrastructure segments (Technology and Energy) recorded segment profits of $14.2 billion in 2008. This actually marked a 13% increase of 2007 with growth coming mostly from increased orders in the Energy businesses related to oil and gas. The businesses included in this segment are probably most comparable public comps such as United Technologies (UTX) or classified by Yahoo!Finance as “Conglomerates” which trade at a 9x multiple. Apply this multiple to profits of $14.2 billion and you get a public market valuation of $127.8 billion.

GE Consumer & Industrials business reported $0.4 billion in segment profit in 2008, down 65% from 2007. The best comp to this business might be Royal Philips Electronics (PHG), unfortunately this business actually reported a loss in 2008, a testament to GE’s performance in this segment. Philips is included in Yahoo’s “Consumer Goods / Electronics” segment and has an average P/E of 18. Thus, applying a similar valuation to this segment, we get a $6.4 billion valuation.

NBC/Universal reported segment profit of $3.1 billion in 2008 roughly flat with profit in 2005, 2006, and 2007. Disney (DIS), owner of the ABC media network and the Disney studio entertainment business is likely the best public comp to NBC/Universal (the NBC TV and Radio network and Universal Studios). Disney trades at a 9.55 P/E which would implie a value of $29.6 billion for NBC Universal.

In sum, we get a valuation of $163.8 billion for each individual GE business segment excluding the Capital Finance segment. Segment profit does not include income tax provision, interest and other financial charges, and corporate overhead. To be conservative, we’ll attribute 100% of corporate overhead to the core segments ($2.7 billion). Since Capital Finance made up 32% of profit in 2008, we’ll only take 68% of income taxes (.68*$3.4 billion = $2.3 billion). And, we’ll assume the majorit of interest and financing charges are a result of GE Finance and thus will not include it in the valuation of the other businesses. Our blended earnings mutiple on the segment valuation of $163.8 billion is 9.2x and, thus, we must adjust out 9.2x $5 billion in additional expenses resulting in a total valuation of $117.8 billion. Remarkably close to our valuation in the discounted cash flow above, don’t you think?

Conclusion
From the two valuation strategies used above, we find that GE’s stock currently trades at a level which basically assumes zero value for the GE Capital Finance business and potentially no growth in its core business. That is, you can buy GE Capital Finance and as well as any growth in one of America’s leading consumer products, infrastructure and media businesses for free. It would seem to me that GE shares continue to offer a very compelling value proposition to new investors.

Full Disclosure: Author is long shares of GE at the time of writing. No other positions in stocks mentioned in this post.