Research Articles

Should Dividend Growth Investors Forgive General Electric?

Julie C - Thursday, July 14, 2011

There was a time in the not-too-distant past when General Electric Co. (GE) was the darling of Wall Street and everybody's favorite stock to own.  This was especially true during the Jack Welch Era, which spanned the years 1981 to 2000.  In truth, I agree that Jack Welch should have been given a great deal of credit for the job he did in profitably running this large conglomerate.  However, as I will soon demonstrate, I feel that Jack was given undue credit for General Electric’s stock price action during the last five years of his tenure.

The Jack Welch Era

The following logarithmic F.A.S.T. Graphs looks at the record that Jack Welch created at General Electric (GE) over the last decade of his reign.  From 1992 to calendar year 2000, General Electric’s earnings-per-share grew at the above-average rate of 13.1% (the orange line plots earnings multiplied by a True Worth™ PE ratio of 15).  This orange earnings justified valuation line, represents General Electric’s intrinsic value based on the company’s record of earnings growth over this time frame.  The blue line on the graph serves as a barometer and represents a normal PE ratio for General Electric of 25.3.

From the historical earnings and price correlated graph we see that during the years 1992 to 1995, price and earnings correlated very closely as the black monthly closing stock price tracked earnings.  However, towards the end of 1995 through year-end 2000, General Electric's stock price rose continuously, ultimately soaring far above its earnings justified valuation.  The point I'm trying to make is that I give full credit to Jack Welch for the creation of the orange line, which represents the operating results that General Electric achieved under his leadership.  However, the price action results should be credited to the stock market, not Jack, because he has no control over stock price.

My position is that the monthly closing stock price (black line) and the normal price earnings ratio (blue line) were generated by stock market action of which Jack Welch, or any CEO for that matter, has no real control over.  Keep in mind that the last years of Jack's reign at General Electric were during the infamous "irrational exuberant period."  Therefore, although Jack did a terrific job at General Electric running the company, at the time he was retiring the market was overpricing General Electric’s stock to the extreme. 

Consequently, from the nine-year performance results associated with the earnings and price correlated graph below, we discover the shareholder returns that General Electric produced (26% including dividends) were almost double the operating results that Jack produced (13.1% earnings growth and a dividend that increased every year).  General Electric closed calendar year 2000 at a price of $47.94, however, the earnings justified valuation (the orange line) only indicated a fair value of $20.

 

The following F.A.S.T. Graphs™, represented in normal scale with earnings (green shaded area) and dividends (light blue shaded area), even more dramatically illustrate how overvalued General Electric was when Jack retired.  Therefore, as I previously stated, Jack deserves a lot of credit for growing the company’s earnings-per-share at such a high rate.  However, an irrationally exuberant stock market deserves the credit (or blame) for the high valuation that General Electric was trading at from 1997 to 2000.

The Jeffrey R. Immelt Era – Pre Great Recession

The following earnings and price correlated F.A.S.T. Graphs looks at General Electric Co. (GE) when Jeffrey R. Immelt first took the reins up to just before the great recession of 2008.  There are two points that I emphasize with this graph.  First, in order to be fair to Mr. Immelt, we should acknowledge that General Electric (GE) was significantly overvalued when he took charge.  Second, we should give him the same credit we gave Jack Welch regarding operating results.

Mr. Immelt orchestrated a steady, and above-average earnings growth rate of 8.9% (the S&P 500 grew earnings at 5.7% per annum during this same time frame).  However, when we look at the performance results associated with the earnings and price correlated graph from 2001 to 2007, we discover that shareholders had a negative total return, even when considering dividends.  But my point is, the culprit was over-valuation, not poor management of the business.  From the standpoint of rewarding shareholders, Mr. Immelt was behind the eight ball from the get-go because he inherited a highly inflated company.

The Complete Jeffrey R. Immelt Era

When we look at the complete Jeffrey R. Immelt Era by looking beyond 2007 up to and through the great recession, we discover real reasons for General Electric's recent poor performance.  A major fact of the Jack Welch legacy was an aggressive campaign in the early to mid-1990s to make General Electric a dominant player in the growing financial services sector.  Consequently, by the end of the decade financial services revenues grew from a mere 25% to 30% in the late 80s, to over 60% of General Electric revenues by 1996.

Therefore, mostly attributable to the financial debacle of 2008 and 2009, General Electric, with its huge exposure to this sector, saw earnings fall 16% in 2008 followed by a 44% drop in 2009.  As the following earnings and price correlated graph illustrates, General Electric’s stock price followed their earnings down.  From the accompanying performance chart we also discover that this financial stress forced General Electric to cut their dividends by 34% in 2009, and an additional 49% in 2010.

On a more positive note, General Electric (GE) today is a more balanced conglomerate than it was just prior to entering the great recession of 2008.  The newly named GE Capital provided just 30% of revenues for the fourth quarter of 2010.  And most importantly, GE Capital is once again contributing to the firm's profitability as the financial services business is steadily improving.  And overall, General Electric has begun growing earnings again, which have led to three modest dividend increases in the last 12 months.

Nevertheless, even when considering all the mitigating factors, General Electric shareholder returns under Jeff Immelt have been less-than-satisfactory and below-average.  As a result, this once beloved Wall Street darling has become reviled by most investors.  On many levels I find this ironic because I remember being severely chastised for warning shareholders about the extended valuation of General Electric shares in the late 90s.  The stock was going up, Jack Welch was a genius and how dare I criticize this great American company.

General Electric - The Last 20 years

The following F.A.S.T. Graphs summarize what has been written in this article thus far.  A picture is worth 1000 words, and the following pictures speak volumes about what really happened with this great American business and its recent history management team.  We see a solid earnings growth record where both Jack Welch and Jeffrey Immelt contributed.  We also see how the company was punished during the great recession by focusing more on services than manufacturing.  Jack Welch started it, Jeff Immelt inherited it, and he is left with the job of fixing it.

Additionally, the following pictures also tell us a lot about valuation based on emotion rather than fundamentals.  The excessive overvaluation we saw during the irrational exuberant period was painfully and rapidly corrected when General Electric’s profitability growth slowed down from 2002 to 2005, even though it continued to grow modestly.  However, after General Electric's stock price reverted to the mean, their stock price once again tracked earnings up to and through the great recession and into the current recovery.  Finally, through the associated performance chart we see the blemishes on dividend growth that earnings weakness created.

This last graph shows the same picture logarithmically.  The relationship between stock price and earnings is clearly evident when examining this graph.

General Electric - The Future

The following estimated earnings and return calculators are based on consensus estimates of leading analysts reporting to FirstCall and Zacks.  The first graph shows that the consensus estimates of 14 analysts reporting to FirstCall expect General Electric (GE) to grow earnings by 15% per year for the next five years.  If General Electric (GE) succeeds in achieving these earnings growth targets, the implied annual rate of return at year-end 2016, assuming a normal PE ratio of 15, would be 18.3% per annum including dividends.

The following five year estimated earnings growth rate, provided courtesy of MSN Money, reports that the consensus of approximately 11 analysts reporting to Zacks expect a slightly lower earnings growth rate of 12.4% per annum over the next five years.

If the Zacks’ estimates are correct, then General Electric would still amply reward shareholders with a 16.7% estimated total return over the next five years.  Implied in both of these estimates are dividend increases consistent with the expected growth rates.

The following earnings yield estimator is based on General Electric Co. (GE) achieving the FirstCall estimated earnings growth over the next 10 years.  Although I recognize that making a forecast 10 years in advance is fraught with peril, it is offered only as a "what if" scenario.  The focal point for offering this graph is the dividend growth yield opportunity, or what many like to call the yield on cost potential going forward.  This would represent the primary reason why dividend growth investors might want to consider forgiving General Electric.

Watch the following video for a live interactive version of the above F.A.S.T. Graphs™ presentation.

General Electric in Pictures

As we all know, General Electric (GE) is one of the largest and most diversified conglomerates in the world.  General Electric organizes its businesses into the following five segments: GE Capital approximately 30% of revenues, Technology Infrastructure approximately 25% of revenues, the newly reorganized NBC Universal representing about 12% of revenues, Home and Business Solutions representing about 6% of revenues, and finally Energy Infrastructure representing about 27% of revenues.

During their most recent earnings call, management reported that they expect to increase research and development spending by more than 12% in 2011.  Additionally, CEO Immelt recently reported that General Electric has a target of boosting research and development spending to 6% from 2% of industrial revenue. This most recent increase has achieved that goal, and therefore, no further increases of R&D spending are indicated.  If General Electric is capable of meeting the consensus analysts estimated growth targets reported above, these research and development expenditures and efforts will need to bear fruit.

However, due to the complexity of this highly diversified industrial conglomerate, a full detailed review of their R&D is beyond the scope of this article.  On the other hand, since a picture is worth 1000 words the following excerpts taken directly from the GE research section of their website provides insights into the complexity and the opportunity that many of their projects offer.  The first set looks at industry opportunities, followed by technology initiatives.

INDUSTRIES

 

TECHNOLOGIES

From the above it should be clear that General Electric is a complex organization with many intriguing opportunities covering numerous industries.  It would be hard to not acknowledge the growth potential that most of the above projects potentially could provide General Electric.  From what the above depicts, General Electric's future could be both interesting and highly profitable.

Conclusions

I have recently read many articles covering General Electric Co. (GE) and its stock.  Most of these articles were focused on General Electric’s resurgence as one of America's great companies.  However, due to its stock performance over the past decade, especially over the last five years, these articles were met with strong and even heated objections by many readers.  Therefore, a great motivation for my interest in authoring this article was to cast a light of truth on what really occurred with this company and its recent management.

Jack Welch does deserve a lot of credit for the job he did as CEO of General Electric.  However, he is often given much more credit for General Electric's stock price action than he truly deserved.  Much of the performance under Jack's reign was the result of excessive valuation more than strong operating performance.  In other words, the excessive price rise was not Jack's fault, but he deserves recognition for the operating excellence he achieved.

In contrast, Jeff Immelt does not deserve all the criticism that has recently been thrown at him.  He inherited a massively overvalued company with a large and arguably out of control financial services segment that he did not create.  Jeff joined GE in 1982, and served as president and CEO of the GE Medical Systems segment, a unit with $12 billion of revenue. Therefore, I would argue that the true Jeff Immelt legacy has yet to be written.  As General Electric Co. (GE) looks to the future, Jeff Immelt’s skills and abilities as chairman and CEO are yet to be fully recognized.

But the most important reason that I wrote this article was to illustrate how price action, even when it's irrational, can color people's views about a company and its investment merit.  In many cases, stock price action may or may not be representative of the respective company’s true intrinsic value.  However, most people take their cue from price action while mostly ignoring fundamentals altogether.

At today's price and valuation, General Electric Co. (GE) offers the dividend growth investor an above-average yield with the potential to grow at an above-average rate.  The truth is that General Electric is a great American company, and the truth is that the market once priced this company beyond what their fundamentals justified.  And, it's also true that the company recently faltered, but its most recent earnings reports indicate that it has begun righting the ship.

But the biggest truth, is that General Electric Co. (GE) is a solid franchise with intriguing growth prospects.  As investors we should never forget that we are always buying the future not the past.  Although I've never owned this blue-chip, I have often longed to.  However, as this report illustrated, it was very difficult, especially during its heyday, to invest in this company at a reasonable price.  Yet, when it was overvalued, was also when everybody wanted to own it.  But now that General Electric Co. (GE) appears to be reasonably priced with a solid and potentially growing yield, investors are loath to own it.  I believe it's at the very least, worthy of further research. 

Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.


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"Chuck - Thank you for your well thought out articles. I tend to be a visual type of person so I really appreciate the F.A.S.T. Graphs™ approach."


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“Your F.A.S.T. Graphs™ put all of this in a single artful picture and the accompanying spreadsheets hammer home the point.”


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