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Stock Analyst Update

We've Downgraded GE

We've changed the firm's economic moat rating to narrow and reduced our fair value estimate.

Mentioned:

We have downgraded  GE’s (GE) economic moat rating to narrow from wide and reduced our fair value estimate to $15.70 from $19 as we transition coverage to a new analyst. We retain both our high uncertainty and Poor stewardship ratings, but consider many actions taken by new CEO John Flannery to be bold steps in the right direction.

We still believe GE’s aviation and healthcare segments boast wide moats, and while the firm this week announced plans to separate healthcare, existing shareholders will still own 80% of this attractive asset after the corporate action. Our downgrade of the consolidated moat rating stems from weak performance in other segments, chiefly from the drag of GE Capital (including recent multi-billion-dollar unexpected reserve requirements and a litany of liabilities) and recent significant revenue and margin reduction in the large-revenue power segment. Together, these factors reduce our confidence that GE’s excess returns will persist 20 years. In fact, we project that after several more years of value destruction, in the final two years of our five-year discrete projections GE will produce returns on invested capital that only barely exceed its cost of capital (by less than 200 basis points).

The strongest lever reducing our fair value estimate is an increase in our estimate of the cost of equity from 9% to 11%. For many diversified industrials, we employ a 9% cost of equity assumption, but no others incorporate such a staggering loss-making capital segment. The second motivator for our cost of equity increase is greater-than-anticipated fundamental volatility at power, demonstrated when segment operating margins dropped from 16%-17% in 2012-14 to about 5.6% last year. Another key valuation factor is our moat downgrade. Whereas (consistent with our methodology) we previously modeled excess returns after our explicit forecast to endure 15 years, we now reduce this excess return period to 10 years.

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Joshua Aguilar does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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