There’s an old saw in stock picking that “if you take care of the downside, the upside will take care of itself.” Unfortunately, that saw doesn’t yet apply to General Electric Company (NYSE:GE) stock.
Even though the GE stock price has come down, and even though the stock has stabilized over the past two weeks, the downside isn’t yet taken care of. In fact, GE stock still has to grow into any earnings-based valuation. And it’s downright expensive based on the company’s own cash flow expectations.
General Electric isn’t doomed by any means. GE news coming out of its Investor Update on Nov. 13 looked negative to me, as I wrote at the time. But the news isn’t all bad. It was only a few months ago that I admitted to being intrigued by the contrarian case for General Electric.
But the problem remains that GE’s valuation is high, not low. Even after an ugly performance this year, the stock price of General Electric still has plenty of potential downside ahead of it. And that colors any efforts to try and time the bottom in the stock.
GE Stock Price Based on Earnings
One of the many disappointments in the Investor Update,which sent GE stock down 12% over two sessions, was the company’s guidance for 2018 earnings. GE projects 2018 EPS of $1.00 to $1.07, below consensus (at the time) of $1.14 and implying a modest decline from 2017 figures of $1.05-$1.10.
That likely decline will come despite aggressive cost-cutting that should help profits next year. With multi-year turnarounds required in the Power and Healthcare businesses, 2019-2020 growth seems likely to be modest as well.
And yet the GE stock price still sits at 17.5x the midpoint of that 2018 guidance. Honeywell International Inc. (NYSE:HON), which has outperformed GE both as a stock and a business, trades at 19.3x forward earnings, with a better near-term growth profile.
As such, it seems unlikely that GE’s earnings multiple will expand much, if at all, going forward. Investors can buy HON for a roughly similar valuation.
There are similarly challenged companies with better dividends – think International Business Machines Corp. (NYSE:IBM), which I like at these levels, or even a company like Target Corporation (NYSE:TGT) – available for 11-13x forward earnings.
Are investors really going to pay 20x earnings or more for GE stock? It seems unlikely. If they don’t, it’s hard to see how the GE stock price gains much in the way of traction, given that earnings growth is likely to be relatively slow.
Cash Flow and the GE Dividend
GE news is even worse when it comes to the cash flow statement. The reason GE cut its dividend 50% was because its cash flow simply couldn’t cover the payment. Year-to-date, GE actually has burned $1.5 billion in cash. Guidance suggests just $6-7 billion in free cash flow in 2018.
Using the midpoint of that range, GE stock trades at 24x forward free cash flow. That’s simply a huge number.
Meanwhile, the low cash flow adds to long-running concerns about GE’s accounting and the quality of its earnings. It limits the potential for dividend increases going forward. Even the halved dividend is taking up roughly two-thirds of next year’s free cash flow, leaving little for debt reduction or share buybacks.
That lowered dividend also makes GE stock much less attractive to income investors. GE stock has moved from being the highest-yielder in the 30-stock Dow Jones Industrial Average to the 11th highest. And, again, without earnings and cash flow growth, there’s not much reason to see that payout rising sharply any time soon.
GE News Can Get Worse
So, what’s the potential downside in GE stock? From here, it looks like $10-$12. Modest disappointment in 2018 EPS and a low double-digit multiple, like that given IBM or fellow Dow component AT&T Inc. (NYSE:T), gets the stock to that level.
So does a mid- to high-teen P/FCF multiple which hardly is outrageous itself. And GE stock still would yield 4%+ at those levels, where it traded before the dividend cut became an inevitability.
Again, I’m not arguing the GE stock price necessarily will reach $10-$12. But it can do so in a reasonably plausible scenario. Given that upside seems potentially capped, at least for the near term, GE stock just doesn’t seem to be worth that risk.
As of this writing, Vince Martin has no positions in any securities mentioned.
