GE – Follow the (New) Words – Buy!

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

May 11th, 2017

GE – Follow the (New) Words – Buy!

  • GE continues to look like one of the best value opportunities in the Industrials & Materials space and its underperforming start to the year presents an intriguing entry point in our view
  • While GE has been one of the most unrealistically optimistic in our group over the past 10 years, 2016 was better, and we see conditions in place for a possible inflection point as we have seen at DOW, DD, APD, and others:
    • It has been established that there is a problem at GE – manifested in financial and stock underperformance – things are bad!
    • This underperformance has been called to attention by a credible activist investor
    • Management is now incentivized – to keep their positions in the first place and to meet the new compensation targets for industrial earnings
  • The improvement in conditions in Q1 ’17 versus a year ago was evident at a high level – word clouds in Exhibit 1 summarize mentions of key words on earnings calls
    • Optics of a negative industrial cash flow number in Q1 may have weighed on the stock but was primarily a working capital/timing issue – range of $12-14B in industrial cash flows for 2017 was maintained
  • Our previous projection of $2.50+ in earnings by the end of the decade remains very achievable in our view
    • If the growth rates seen in the industrial businesses in Q1 can be sustained, GE would earn close to $2.10 in 2017 (consensus is $1.89)
    • With an additional $0.20 possible from further improving the ROA in the industrial businesses to a peer average of 15%, it would take only 5% annual growth to get the company to $2.55 by 2019 (and close to $2.70 by 2020)
  • We think GE could reach the mid-$30 range within a year to 18 months, representing ~25% upside from current pricing
    • The move will happen quickly when it does, and we see downside as limited with dividend support (3.3% yield) and an increased focus on buyback – more shares repurchased in Q1 ’17 than in the entirety of 2014 or 2015

Exhibit 1 – Frequency of key words in GE quarterly earnings conference calls

Source: Capital IQ and SSR Analysis

Overview

GE has been the laggard year-to-date – Exhibit 2 – despite positive surprises in earnings and revenue in Q1 2017 – Exhibit 3 – and despite a more active Trian, in terms of discussions and agreements with the company on growth goals and compensation.

We continue to believe that GE may be at or nearing a point of inflection – driven by three factors:

  • Recognition that things are bad and a fix is required
  • The presence of a well-qualified activist – one with a strong track record of effecting change
  • A compensation and performance program that will either focus management to get the right job done, or allow investors to insist on management change with the supporting data to drive that change

Exhibit 2

Source: Capital IQ and SSR Analysis

Exhibit 3

Source: Capital IQ and SSR Analysis

Activists generally have a good track record of fixing optimists and GE has been one of the most optimistic companies in the Industrials space – Exhibit 4. Whether they are successful because they cause management to become more self-aware and tone down ambition to more appropriately fit the core company strengths, or whether they help management realize what is needed to meet ambitious targets and execute better depends on the circumstance, but it does not matter. The key is to get capital allocated appropriately and then drive the business to maximize the return on the capital that has been deployed.

A greater focus on execution at GE will likely drive one of a couple of outcomes: it will either produce the better earnings growth that we identified in our earlier piece on GE, with the analysis summarized in Exhibit 5, or it will provide a compelling case for a change in direction – break-up, new management etc.

Either way, change is likely coming!

Exhibit 4

Source: Capital IQ and SSR Analysis

Exhibit 5

Source: Capital IQ and SSR Analysis

Activists Help Fix Optimists

GE is a very poor predictor of its own potential – and as shown in Exhibit 4, one of the worst in the group. In Exhibit 6 we show the annual data for the last 10 years.

Exhibit 6

Source: Capital IQ and SSR Analysis

Activists tend to help companies focus on strategy and what are and are not reasonable goals – whether that is a focus on cost structure or understanding the real potential returns of the business. Dow Chemical is probably the best example with the arrival of Third Point coinciding with a much more focused and predictable company – Exhibit 7. Dow has been one of the better performers in the sector since that point. Dow will argue that they were on the right path before Third Point arrived, and there is some validity to that argument, but having a strong investor looking over your shoulder does tend to keep consistency.

Exhibit 7

Source: Capital IQ and SSR Analysis

The stories are the same for both Air Products and DuPont, although the charts are not as supportive as they are for DOW – Exhibits 8 and 9. In both cases the activists took time to make change and the initial results were not as clear as they were for DOW – for example the significant DD miss in 2015 was an overestimation of the fortunes of the Ag business made by prior management and before Mr. Breen showed up – since then there have been marked improvements.

Air Products set some very lofty goals and met them for the first couple of years, falling short in 2016.

The most important point here is that all were points of infection for the stock and for shareholder returns.

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ and SSR Analysis

In Exhibit 1 we show the change in sentiment in Q1 2017 by picking key words from the earnings transcript and looking for repetitions – in Exhibit 10 we show the same charts but directly below we show the aggregate for GE, HON, UTX and MMM. Historically, based on the imbedded optimism within GE we would not pay much attention to the tone of an earnings call, but GE appears more bullish than the pack on a qualitative basis and it is possible that this sentiment should be taken more seriously given the new focus.

Exhibit 10

Source: Capital IQ and SSR Analysis

Paid to Wait – Limited Downside

In the meantime, you are paid to wait, with a reasonable dividend yield and a meaningful share buyback – Exhibits 11 and 12.

Exhibit 11

Source: Capital IQ and SSR Analysis

Exhibit 12

Source: Capital IQ and SSR Analysis

©2017, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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