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By Jeremy Glaser and Daniel Holland | 10-19-2012 03:00 PM

GE Keeps Sharpening Focus on Core Business

The near-term outlook for GE is good, but investors should wait for a bigger margin of safety in the shares before jumping in, says Morningstar's Daniel Holland.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

GE reported third-quarter earnings this morning, and I'm here with Daniel Holland--he is a senior equity analyst at Morningstar--to get his take.

Daniel, thanks for joining me.

Daniel Holland: Thanks for having me, Jeremy.

Glaser: So, just first off, what's your take on this quarter? Did it beat your expectations? Was it a little bit below your expectations?

Holland: Earnings were largely in line with where we expected. I guess underneath the covers was where a lot of the deviation happened, where some segments performed a bit better than we expected, and other ones, not so well. But in general, as it typically goes with GE, it was in line with where we expected.

Glaser: No major surprises. Let's look at the energy business. I know that's been kind of a volatile one for them. What happened there this quarter?

Holland: Well, on the main energy business, you have wind turbines, which are being a little bit detractive to both the sales and the margins in the quarter. We expect for that to be persistent for the next year or so just as pricing continues to come down on the wind turbines. The good news is, you are starting to see a lot more natural gas activity, order activity, things of that nature, which give you a little bit more hope for the future. Company is building a better backlog. You have decent margin potential in that portfolio.

So, I kind of look at energy as a tale of two cities. On the wind side, it's not looking pretty and it's not going to be looking pretty for a while, but on the main core energy, gas turbines, steam turbines, things of that nature, that's looking pretty good.

Glaser: How about on transport?

Holland: Transportation, the segment continues to do better than we even expected. The earnings growth in the quarter again was significant double digits. I think north of 30% this quarter. Last quarter it grew 40% over the prior period.

The company is getting a lot of traction with the new locomotives out there. And within that transportation segment is one of the company's new focal areas, which is going to be mining activity. So, that looks to be an interesting focal point for GE going forward and a place where investors could look to see some more material earnings growth.

Glaser: How about GE Capital? This is a unit that obviously gave GE quite a few headaches during the financial crisis. Are those really behind them? What's happening there?

Holland: Well, a few years ago, after the crisis or right in the midst of it, GE set out with a plan to shrink the size of GE Capital, get the balance sheet in line, move out of noncore assets, and really focus on doing the things that they are great at. And to-date, the company has done a lot better than they expected, definitely a lot better than we had expected in terms of getting that portfolio down, and getting it more in line with what you would expect a wide-moat company like GE to do.

So, within the quarter, earnings continued to improve, even though revenues were coming down because of the shrinkage. They are selling assets, which in our mind is a good thing because it's actually getting them away from things that we don't like and moving them more towards, or more exposed to things that are healthy for GE.

Glaser: The company accessed the bond market. Why did they do that right now?

Holland: Well, GE has a $5 billion debt issue coming due in February of next year, and I think that they used the current environment as an opportunity to go ahead, take a lot of debt--the liquidity risk, if you will, out of the picture. During the call, management cited a little bit of uncertainty around the fiscal cliff and just the general low interest rate environment helping them out, but it's interesting about the fiscal cliff because a lot of companies are starting to express some kind of pessimism about what that's doing to the overall economic environment with the uncertainty in the industry.

Glaser: So, it wasn't that they really needed the money right now, but they just figured it would be prudent to go out and get it?

Holland: No real acquisitions, no massive share repurchases, or anything interesting like that. It's just that GE thought that it's a good time now as opposed to later when maybe the interest rates aren't going to be as low as they are right now.

Glaser: How about the shares? Are they attractive?

Holland: Well, right now, shares are trading around $22 a share. We have a $25 fair value estimate on the stock. So, it's slightly below our fair value estimate, but we typically like to see a margin of safety a bit larger before we get too excited about the company.

Glaser: Daniel, thanks so much for talking to me today.

Holland: Thanks a lot, Jeremy.

Glaser: For Morningstar, I am Jeremy Glaser.

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