Many Top Managers Are Bullish on GE

According to our latest holdings data, nine of our Ultimate Stock-Pickers hold a stake in  General Electric (GE), making its stock one of the most widely held by our favorite investment managers. We'd also note that the stock is a top 25 holding for seven of our Ultimate Stock-Pickers' funds, which demonstrates a high level of conviction, in our opinion.

One of those funds bullish on GE is the  Jensen Fund (JENSX). In a recent letter to shareholders the Jensen Investment Committee offered this optimistic long-term outlook for the company:

"The overall commercial finance business at GE continues to be well diversified and while results will naturally come under some pressure in the current environment, we believe that GE is more than adequately capitalized in its finance business and should weather the storm. Additionally, the strength in the infrastructure business, the recovery of the health-care business and the continuing solid cash flow generation for the company as a whole should provide GE opportunities to create shareholder value in the long term through its continued solid business performance."

Legendary investor Warren Buffett is also very bullish on the company. In October of last year, when  Berkshire Hathaway  (BRK.B) invested $3 billion in a private offering of GE perpetual preferred stock (see our Analyst Note for further details), Buffett said the following:

"GE is the symbol of American business to the world. I have been a friend and admirer of GE and its leaders for decades. They have strong global brands and businesses with which I am quite familiar. I am confident that GE will continue to be successful in the years to come."

So, given this bullish sentiment on GE, I thought it would be a good time to check in with Morningstar analyst Daniel Holland to dig deeper into this 5-star stock.

Daniel, will you please give us a brief overview of the General Electric's business?

General Electric has a wide portfolio of businesses with heavy concentrations in infrastructure, health care, and financial services. It manufactures and services a variety of large durable goods, such as jet engines and locomotives as well as power turbines. In addition, GE owns NBC Universal, which develops and distributes media content. Currently GE receives approximately 60% of its revenues from outside of the United States.

What is the basis for the company's wide economic moat rating?

Unlike many traditional manufacturers, GE provides maintenance and other services to customers after the original purchase. These agreements provide both annuitylike revenue streams and help GE get closer to customers and understand how its products are being used in the field. Being close to the customer develops sticky relationships, making it difficult for customers to leave. GE also benefits from strong economies of scale. The firm is able to spread its brand and employees across all of its product lines, resulting in lower startup costs for new projects and generally higher probabilities for success in new product launches. These advantages have translated into average returns on invested capital of around 17% over the last three years, with 2008 on pace to meet that standard.

You believe the company will benefit from a global infrastructure boom. Is this still realistic, considering the widespread financial crisis and economic slowdown?

The global slowdown has added a bit of uncertainty in the near term regarding the growth of infrastructure, but the recently announced infrastructure stimulus package by the Chinese government as well as the incoming Obama administration reveal that governments are looking to restart the economies with a focus on infrastructure. This bodes well for GE and other companies that are heavily tied to infrastructure equipment. An additional tail wind is the renewable energy portfolio standards, which will require utilities to allocate more of their overall power portfolio to renewable sources. As the leading manufacturer of wind turbines, GE has positioned itself to take advantage of the stronger demand. Capital is still tight, so don't expect to see gangbuster growth in 2009, but we expect infrastructure to be somewhat resilient.

How would you characterize the firm's financial health? Will the company be able to weather the current storm?

GE is in good financial health. Its debt has a triple-A rating by the major ratings services and its cash-generating ability is strong. GE's financial unit has recently announced restructuring actions that will reduce leverage and improve its funding sources to shift from depending entirely on wholesale financing. Although this will increase financing costs for GE, we think that the reduction in the riskiness of the financing model is welcome. The industrial operations maintains a free cash flow/sales ratio of around 15% and has enabled the firm to pay a steady dividend. GE has committed to pay a dividend of $1.24 per share for 2009.

How do you view GE's management team?

GE's management team has done a good job of giving the firm a better focus. The financial unit once was a hodge-podge of insurance assets, mortgages, and other things that didn't make much sense. Encouragingly, the proportion of moat-worthy assets has increased over time. The biggest bet that management has made is that infrastructure is the best growth engine for the firm, and that has played out fairly well over the past couple of years.

Why do you believe the stock is undervalued?

The stock continues to be undervalued simply because of GE's heavy exposure to the banking environment. With GE's unexpected earnings miss in the first quarter of 2008, many investors were left wondering what was inside of the mysterious business that generated half of the firm's profits. In our valuation we assume that GE's bank is worth its current book value, roughly $60 billion or $6 per share, which accounts for GE's reduction in leverage, higher sources of financing costs, and higher delinquency rates to accompany the current credit cycle. The industrial side of the business may not have a stellar 2009, but even when we factor in declines in 2009 and a subsequent return to mid-single-digit growth, we reach a fair value of $28 per share. Our Consider Buying price of $19.60 implies revenue growth averaging only 2% over the next seven years on flat margins. These are hurdles that are easily within GE's reach. The dividend yield and the potential for further growth are also very appealing.

What do you consider to be the key risks for investors?

Although GE has announced a restructuring in the finance business, market conditions can make it expensive for GE to raise debt financing to fuel its finance portfolio. A prolonged credit freeze has the potential to directly hit GE's pocketbook and make it difficult to roll the $45 billion of debt that it wanted to roll in 2009. Indirectly, GE's customers may continue to delay purchases of large-ticket items, resulting in a weaker backlog and lower orders. Lastly, GE's financing receivables portfolio has begun to see delinquencies increase at an alarming rate: U.K. mortgages hit a high of 17.83% in the third quarter. The firm has been provisioning for these losses, but we expect higher allowances in the future until the global economy finds its footing.

Anything else you'd like to add?

Given all of the news that has come out about GE since the end of September, it appears that the firm is taking a more defensive stance, which investors should welcome. More importantly, GE is taking advantage of the Treasury's commercial paper program and having its bonds backed by the FDIC, which will help to lower financing costs for the firm. The rapid growth of GE's deposit-based financing broadens the company's sources of funding and helps the company avoid being locked out of debt financing activities, and it also helps to further develop relationships with customers. Many of the firm-specific uncertainty elements have been addressed, and now the bigger question is the broader market.

The Ultimate Stock-Picker's Take
I tend to agree with Daniel's views on GE and the risk/reward trade-off with the stock looks very attractive to me. The shares are presently trading at just over half of our fair value estimate and the stock also looks cheap on a variety of other metrics--price/earnings over the trailing 12 months is less than 8 times, versus the company's five-year average of about 17 times, and price/free cash flow over the trailing 12 months is less than 6 times, versus its five-year average of around 16 times. GE boasts an attractive 7.8% dividend yield, trouncing the current 10-year Treasury yield of 2.4%. So, GE, like  ConocoPhillips (COP) (see "Strike Oil by Following in Buffett's Footsteps"), could be a worthy addition to our Ultimate Stock-Picker's portfolio, but I want to dig deeper into more stocks on our watch list before making a final decision on these two stocks. To be among the first to see our analysis of other stocks on our watch list as well as my eventual decision on GE, please be sure to sign up for our free e-mail alerts.