General Electric Company (NYSE: GE) has been added to our ValueHuntr portfolio. This company is an odd one for us to include, as it is a blue-chip widely covered by Wall Street analysts. However, it is clear to us that GE’s latest downturn has been driven by fear and uncertainty rather than the fundamentals. We estimate that GE’s market value of $77B ($7.41/share) at yesterday’s closing is lower than our estimated value for the GE Technology Infrastructure segment alone, making it one of the most undervalued Dow components at the moment.
General Electric Company (GE) operates as a technology, media, and financial services company worldwide. The company was founded in 1892 and is based in Fairfield, Connecticut. GE is the only company remaining in the Dow index today from the original 12 Dow components at its creation in 1896.
This segment produces gas, steam, and aero-derivative turbines; generators; and combined cycle systems, as well as provides water treatment services and equipment. This segment also sells surface and subsea drilling and production systems, floating production platform equipment, compressors, turbines, turbo-expanders, and high pressure reactors to national, international, and independent oil and gas companies; and offers equipment overhauls and upgrades, pipeline inspection and integrity services, remote diagnostic and monitoring, and contractual service agreements.
This segment manufactures jet engines, aerospace systems and equipment, and its replacement parts, as well as provides repair and maintenance services for commercial aircraft; military aircraft, including fighters, bombers, tankers, and helicopters; marine applications; and executive and regional aircraft. This segment also produces healthcare products, including diagnostic imaging systems; offers transportation products and maintenance services; provides enterprise solutions using sensors for temperature, pressure, moisture, gas and flow rate, as well as non-destructive testing inspection equipment.
This segment engages in the production and distribution of films and television programs; operation of television stations and cable/satellite television networks, as well as theme parks.
This segment offers loans, leases, and other financial services to customers, including manufacturers, distributors, and end-users of equipment and major capital assets. Its Consumer & Industrial segment produces various house hold appliances, lighting products, and electrical equipment and control products, as well as provides related services.
The latest 10-K submitted by GE shows every company segment is profitable, including its GE Capital arm. Though GE is a complex company with a lot of moving parts, we can get a sense of how much each segment is worth individually by assigning the appropriate sector multiple to each. Our estimated segment value is simply the product between the assigned multiple and the reported earnings for each segment. Mathematically, the multiple is the number of years that an investor is willing to wait before he breaks even with his investment given the earnings produced. Therefore, in the face of lower earnings expectations and current market conditions, we assign a lower multiple to those segments with the lower earnings prospects, and vice versa. For the sake of conservatism, we have assigned multiples that are all lower than the current multiple of the S&P500 average.
Our quick analysis shows that, based on the earnings each GE segment generates and the poor market conditions (reflected on the low multipliers), GE is worth at least $139B today ($12.68/share) The sum of all GE segments is nearly twice GE’s market value of $77B ($7.41/share) at yesterday’s closing. Again, this is a rough estimate, but it is useful because it allows us to place a value to each segment. Obviously, this value would be greater if the future expectations of the economy and the company improve (greater multipliers).
GE’s assets, particularly those within GE Capital, have lately been scrutinized due to GE’s exposure to declining mortgages. The latest 10K shows that GE has consolidated assets of $198B, of which $53B are investments in GE Capital. This is essentially the equity value of GE Capital’s portfolio. Therefore, any potential write-downs in GE Capital’s portfolio will ultimately lower the reported shareowner equity. The report indicates that as of December 31, 2009, the net equity per share of common stock is $9.53, after adjusting for possible dilution from warrants.
The following analysis attempts to estimate what a worst case scenario for GE Capital would look like for GE as a whole, and the effects it would have on the company’s balance sheet.
Focusing on GE Capital
A critical misconception behind GE’s stock price plunge is that GE Capital has nearly $45 billion in commercial mortgage backed securities (CMBS) that will need to be marked down. However, our analysis shows that this completely wrong. The latest 10-K shows GE does not hold $50 billion in CMBS, but rather in a commercial real estate loan book, a senior secured position where GE underwrites each individual property. This means that the $34 billion of equity is the actual value of the properties, with over 80% of that with no third party debt. GE currently has $2.9 billion of CMBS in its investment portfolio, as reported in its 2008 10-K. GE Capital’s balance sheet is shown below.
We have made the following adjustments to GE Capital’s balance sheet to reflect a worst case scenario for GE.
Reality: GE Capital accounts for its real estate holdings at the price they paid for them, depreciating the values over time, rather than periodically marking them to their current market values.
Adjustments: We have marked down GE Capital’s real estate asset holdings by 30% to reflect their possible current market value.
Reality: The balance sheet does not include the potential effects of a credit downgrade.
Adjustments: If the long-term credit rating of GE Capital were to fall below AA–/Aa3 or its short-term credit rating were to fall below A–1+/P–1 GE Capital would be required to provide approximately $3.5B of capital to various entities to account for this increase in credit risk.
Reality: The balance sheet does not include any potential losses due to deteriorating conditions in the market since December 31, 2008.
Adjustments: Increased delinquency rates on on-book and off-book equipment financing loans and leases from 2.17% to 3.00%. Also, increased managed financing receivables delinquency rates, including defaulting consumer credit cards, from 7.47% to 10%.
Reality: Latest balance sheet excludes benefits in dividend cut announced February 27, 2009.
Adjustment: Dividend cut from 31 cents to 10 cents will allow GE to attain an extra $9B a year.
Reality: GE Capital holds $41B of investment securities, some of which are backed by consumer and commercial mortgages. Unrealized losses were included in fair value, but additional losses will mount if market continues to deteriorate.
Adjustments: Marked down all investment securities at GE Capital by an additional 15% to reflect the possibility of further deterioration in asset-backed securities and continuing decline in property values. This adjustment resulted in an additional $7B write-down to the fair value calculations reported in the 2008 10-K. GE’s Capital worst case scenario adjusted balance sheet is shown below.
Our analysis shows that in a worst case scenario, GE Capital is still valued at nearly $9B in equity, which is an 83% reduction in equity compared to that reported in the 2008 10-K. Writing down this equity in the consolidated balance sheet results in an adjusted equity of $71B for GE as a whole, or $6.51/share.
At its $7.41 close yesterday, GE is trading near our estimate worst case scenario estimate of $6.41. However, we believe that this worst case scenario is very unlikely to play out. GE Capital accounts for its real estate holdings at the price they paid for them, depreciating the values over time, rather than periodically marking them to their current market values. We believe this is the right approach for GE as a long-term investor, as unlike other financial institutions, GE is not forced to sell any of these investments to raise additional cash. Furthermore, the latest dividend cut saves GE an additional $9B a year, which can be preserved as cash in the near term. We expect the unrealized losses in mortgage-backed investment securities to shrink as the price of property values stabilize in the long term. In general, we believe our earnings-based valuation of roughly $12/share is closer to the company’s intrinsic value. This represents a nearly 50% discount to the current market price of $7.41 with a high probability of upside in the near term, once market fears about GE Capital assets start to dissipate. For this reason, GE has been added to our ValueHuntr Portfolio.
[Full Disclosure: We currently have a holding in GE. This is neither a recommendation to buy or sell any securities. All information provided believed to be reliable and presented for information purposes only. Do your own research before investing in any security.]