Phil Guziec: Hi, I'm Phil Guziec, co-editor and portfolio manager of Morningstar OptionInvestor newsletter, and I'm here with Daniel Holland, Morningstar's General Electric analyst. Welcome, Daniel.
Daniel Holland: Hi there. Thanks for having me, Phil.
Guziec: So, we've recommended customers write a put on General Electric, and I wanted to talk to you about the valuation of General Electric, scenarios around that valuation. You think the company's pretty undervalued at current prices and that it's worth $25 in a downside scenario, or a consider buy scenario is $12.50.
I would like to talk to you about how we get there, what they do besides make light bulbs, and break down their business and the potential outcomes for the different pieces of the business.
Holland: Sure. Well the first thing when I'm thinking about General Electric, you always want to split it up into two businesses: the industrial business, which has the light bulbs and the gas turbines, and all those things that people are familiar with coming out of General Electric, and then GE Capital, which is their bank or their financing arm, where GE funds a lot of different kinds of businesses, lends money, things like that.
Guziec: So why don't we think about those scenarios going forward for GE Capital. What's the dire scenario, and how well positioned are they for that dire scenario? I know they have some commercial real estate exposure, and that's one of the sources of concern right now in the market. Versus a baseline scenario, or what you think is more likely to happen.
Holland: Right. The biggest sore point with GE Capital is that exposure to commercial real estate. Of their, say, $450 billion financing portfolio, roughly $80 billion of those assets are sitting in commercial real estate. Either GE owns the property itself, or it's a lender in the property as properties capital structure.
So whenever you hear about fluctuations in commercial real estate market, big job losses, unemployment, things like that, you get a little bit concerned about what GE's position is, and how they're going to be able to weather that.
One of the good things that, or one of the things that have helped give us a little bit of confidence about commercial real estate with GE, is the fact that it's balance sheet is relatively strong, and that in a dire case where the tenants leave, GE doesn't necessarily have to sell a property or force somebody to sell a property in order to make whole on its deal. That's a good thing when asset prices are down double-digit percentages.
Guziec: So for GE, if it's a credit issue, it's purely a credit issue, it's not a liquidity issue because they're now well-capitalized.
Holland: That's right. So the ability to rework the terms of the loan, figure out if we need to change payment structures, get new tenants in, change the management team, whatever it needs to happen with regards to the property, GE has the flexibility to actually go in and make those kinds of things happen.
That said, it gives the firm, it gives us, a bit of confidence that in worse case scenarios, GE Capital still comes out OK. So last year when we were talking about the commercial real estate exposure, folks were like, let's just whack off 50% of the book and just write it off, it's worthless. Today that just doesn't seem appropriate, it doesn't make sense.
Guziec: But the market is still pricing some of that in.
Holland: To a large degree, because until the end of the crisis, until the end of the losses, we really don't know how severe it's going to be. As you just keep reading the stories, and the quarters trod along, you see that things aren't really going to that dire case scenario.
Guziec: And then light bulbs.
Holland: That's right.
Guziec: Light bulbs and other things. What are the scenarios of outcomes there, and how does that effect the valuation?
Holland: One of the things that gives us a little bit of comfort with regards to the industrial business is that GE has tremendous exposure to energy infrastructure, healthcare, aviation, things that are just big, broad businesses that are GDP growth type businesses.
So if there is global GDP growth, you would expect GE to be able to grow in those environments. Because of GE's exposure, to say, energy, what would have to happen for them not to grow is it maybe in a scenario where GDP grows, but energy doesn't grow.
Guziec: I know we've done quite a bit of research that over the past many decades, GDP growth and energy growth are correlated one-for-one.
Holland: It's a very, very direct correlation, and so thinking about that actually coming to fruition, is a silly exercise in thought. So that gives us a bit of comfort there. The other things that you have to think about, healthcare infrastructure, aerospace, things like that, there's been a lot of tailwind behind healthcare in emerging markets.
When you're looking at countries like China and India, folks that are now able to afford some amount of healthcare are demanding healthcare, and that only increases the demand for more medical products and equipment, and those kinds of things. So the story against industrial is kind of hard to really put down and say it's not going to happen. It's just a matter of timing.
Guziec: So in both cases, the downside scenario for the bank is relatively curtailed, and the downside scenario for the manufacturing business is relatively curtailed.
Holland: That's right.
Guziec: So we've recommended that customers write a put option which would give them, if they wound up having the shares put to them, an effective buy price of $13.50. What is the likelihood of the value of GE being $13.50 or below?
Holland: You know, I guess there are some paths to get there. One thing that comes to mind is if things all of the sudden do happen to blow up at the bank, and the company is required to put in a fair amount of capital -- by that I mean, well in excess of $20 billion of capital -- they would have to dilute equity share holders, or money that would otherwise be going to the equity share holders would be going to the bank, and whatnot.
Those kinds of scenarios would help get you down closer to a $13.50 type price. The thing though is, in a lot of our scenarios, and just thinking about the actual fundamentals of what would have to go wrong in the business of the bank to get down that low, it's tough to see.
You're talking about, well now let's just take the $80 billion commercial real estate portfolio and let's write off 75% of that business to say that it's just not worth what GE says it's worth.
Guziec: And of GE senior and the capital structure, that means all of the building are worth 20% of what they used to be. So pretty unlikely scenario.
Holland: Right. Even in this price environment, we're not down that low yet.
Guziec: Well thanks for taking the time to walk through that with us, Daniel. I'm Phil Guziec, co-editor and portfolio manager of Morningstar Option Investor. We encourage you to join us for other interesting, deeply-researched option investing ideas at option.morningstar.com.