Buy GE Stock? 3 Pros, 3 Cons for General Electric

While GE stock faces risks, there's reason not to be bearish

By Lucas Hahn, InvestorPlace Contributor

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General Electric Company (NYSE:GE) stock owners have had a difficult 2017. The Dow Jones Industrial Average is up 10% year-to-date, but GE stock is down 21.64%, making it the Dog of the Dow.

General Electric Company (GE)
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GE’s previous CEO, Jeff Immelt, worked to reposition the conglomerate as a “digital industrial company.” Under Immelt, GE hired more than 1,800 engineers, invested billions in software development and bought two 3D printing firms. GE also divested its media business and parts of GE Capital. But investors seem disappointed with GE Digital’s revenue.

GE’s new CEO, John Flannery, faces pressure to cut costs. Sources say he plans to reduce staff, although Predix, GE’s platform for the Industrial Internet of Things (IoT), will be exempt.
Over the past few years, GE stock has underperformed its rivals such as 3M Co (NYSE:MMM) and Honeywell International Inc. (NYSE:HON). GE reported $0.87 in earnings per share for the trailing twelve months. Next year, it is expected to earn $1.70 a share.

Its stock seems to have bottomed out as well, but is GE stock a buy?

Here are some points to consider.

GE Stock Pros

Activist pressure: Sometimes when a trusted blue-chip stock underperforms and disappoints shareholders, an activist investor rides to the rescue. Activist investors will pressure management to get the company moving again: cut costs, divest certain businesses and improve operations.

In October 2015, the activist hedge fund Trian Fund Management disclosed its $2.5 billion stake in GE. This made Trian one of GE’s biggest shareholders, and GE remains one of Trian’s largest positions.

Trian made its intentions clear in a white paper it released at the time:

“Trian believes GE could be worth approximately $40 to $45 of implied value per share by the end of 2017 and will seek to work collaboratively with GE’s management to help positively influence corporate events”

High Barriers to Entry: As Trian noted in its white paper, GE makes complex and differentiated products. These include wind turbines, aircraft engines, trains and CT scanners, each requiring thousands of intricate parts.

GE operates in very capital-intensive and knowledge-intensive industries; to set up shop in these sectors you need billions of dollars and thousands of skilled employees. These high startup costs create barriers to entry and protect GE’s profits.

Technology Company: It’s not just hype: GE’s transition to being a digital industrial company is very real.

GE currently employs 20,000 software engineers, including 5,000 in its GE Healthcare division. Last year, its Predix software generated $6 billion in revenue, and GE expects to earn $12 billion from software in 2020.

And as I mentioned in my previous article, GE enjoys high margins from this revenue. Last year a William Blair analyst put GE’s EBIT margin at 35% for software and 50% for data analytics.

History repeats itself. Remember the impact that the growth of Amazon Web Services had on Amazon.com, Inc. (NASDAQ:AMZN) stock? This could be similar. GE Digital could account for a large share of GE’s earnings by 2020.

GE Stock Cons

Disappointing Performance: GE’s performance over the past ten years leaves much to be desired. Trian Partners does not dispute this, attributing it to a “tough decade”.

GE hasn’t performed very well over the past decade. The stock is down 36% over the past 10 years. And this isn’t just a case of the market being irrational: it hasn’t made much progress on sales, earnings and cash flow over the past few years.

GE’s weak cash flow could eventually put its dividend at risk. GE stock currently yields 3.88%, with an annual dividend of 96 cents per share. But over the trailing twelve months, GE earned only 87 cents per share.

Pension Problems: GE operates under a defined benefit pension plan, where the employer promises to pay workers a certain monthly sum when they retire. The employer must set aside money for this in a pension fund and makes assumptions about expected returns.

During bull markets, the value of the pension fund’s assets goes up, and the employer can afford to go a few years without contributing.

The stock market boom of the 1990s increased the value of GE’s pension fund assets. GE reported these pension surpluses as profits, inflating its earnings. In 2001, these comprised 15% of GE’s reported profits.

GE set the expected annual return for its pension fund at 9.5% in 1999, but this proved to be too high in the years that followed.

Now GE’s pension fund faces a $31 billion shortfall, which GE must cover, either by increasing its annual contribution to the fund (and lowering profits) or borrowing money.

Warren Buffett Sold GE: If this wasn’t bad enough, Warren Buffett recently sold his GE shares.

I have to admit, I would feel very nervous about buying a stock that the Oracle of Omaha didn’t like.

Conclusion

Much of the commentary I see on General Electric is backward-looking: people complain about the stock’s underperformance and the blunders that, in their view, GE’s previous leaders made.

But investors need to be forward-looking. Instead of carping on past mistakes by past management, they should ask whether the current management is capable of improving results.

And they should remember the difference between the business and the stock.

The market doesn’t value companies perfectly. A slide in the stock price does not necessarily mean that the company is doing poorly; sometimes investors just lose interest.

Is this drop in the past year justified by GE’s fundamentals? Has the outlook for its business worsened that much?

Or could it perhaps be the fault of nervous or impatient investors?

It’s a difficult call, but I think there’s something to be said for the market overreacting. 

We’ll find out more in November, when Flannery presents his report to investors.

As of writing, Lucas Hahn did not hold a position in any of the aforementioned securities.


Article printed from InvestorPlace Media, https://investorplace.com/2017/09/ge-stock-pros-cons/.

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