General Electric: My Value Trap Concerns Are Triggered

General Electric (NYSE:GE) remains a company in the midst of a challenging and prolonged transformation. Despite recent stock price gains, the long-term picture is less optimistic. Over the past decade, GE's revenues have shrunk, while profitability has dwindled and R&D investments remain modest. Looking ahead, analysts predict only little earnings growth through 2027, and even under these projections, GE's stock appears overvalued, potentially facing a 30% downside.

While GE's restructuring efforts continue, including the upcoming spinoff of GE Vernova, uncertainties loom. Investors should be cautious and mindful of the risks associated with GE's ongoing transformation and the company's historical underperformance compared to the broader market.

Still A Restructuring Story

As General Electric approaches the final stages of its decade-long transformation from a sprawling industrial and financial conglomerate into a more focused set of companies, GE's turnaround has quite a few of unknowns, including when renewables will finally reach profitability and when the Inflation Reduction Act will move toward full implementation. Investors should consider that GE's Renewable Energy business suffers from many similar competitive dynamics that plague GE's Power business, including greater price competition to gain market share and cheaper alternatives from other forms of energy like solar. In that context, GE has consistently written negative earnings from both Power and Renewables, with an operating profit margin of minus 7.6% (as of Q3). And while new equipment orders are accretive for the growth outlook, new orders on negative margins will be dilutive to the bottom line.

Relating to GE Vernova, investors are certainly excited about the upcoming spinoff, which is expected to be finalized by the second quarter of the following year, albeit slightly later than the previously projected timeline by GE. But investors should consider that there is no guarantee that the spin-off will unlock economic value for shareholders. In fact, investors should have a look to what happened to Siemens Energy following a similar restructuring and spin-out of the Renewable Energies business. The problem with spin outs is that they only change the shareholder picture and corporate structure -- they have little to do with shareholder wealth creation. In fact, I like to argue that spinouts from industrial conglomerates are poised to be worse off, losing some of the scale effects and synergies that a business may leverage being a wholly owned subsidiary of a larger entity.

Once the spinoff is successfully executed, GE will undergo a transformation into becoming "GE Aerospace". And neither this segment of GE is without problems. Although the aerospace sector demonstrated remarkable performance in 2022 and 2023, the sector is highly cyclical and may clearly come under pressure in a recession. In Q3, for reference, GE has had to revise its growth expectations for LEAP jet engine deliveries for the remainder of 2023 and the upcoming year due to challenges in the supply chain. Under the new outlook, GE is now targeting a year over year delivery increase of 20% to 25%, a significant reduction from the previously goal of 40% to 45%.

On the bright side, GE has made substantial progress in reducing debt and shedding liabilities, lending a degree of clarity to its future outlook. Specifically, GE's net debt has been reduced to $4.7 billion, compared to an operating cash flow for TTM equal to $6.3 billion.

Fundamentals & Valuation Flash Bearish Signals

On the backdrop of restructuring progress and a supportive macro backdrop in aerospace, General Electric (GE) stock is up about 60% YTD, compared to a gain of only 8% for the S&P 500 (SP500).

Investors, however, should not get to excited about General Electric's most recent share price outperformance. Taking the perspective of the past decade, GE stock is still a big loser on the stock market -- with shares down close to 33%, while the S&P 500 has more than doubled.

The long term share price performance of GE stock is very much in line with the company's historic fundamentals over the period, which suggest that General Electric is a value trap.

Investors should consider that for the past decade, General Electric has failed to grow either top- or bottom-line. In fact, since 2013, annual revenues have fallen from $100.5 billion to $80.5 billion (TTM reference), suggesting a CAGR of negative 2%.

Similarly, profitability contraction has also fallen at a 2% CAGR, on both gross and operating profit. For the trailing twelve months, GE's gross profit has also been only $21.3 billion, compared to $25.8 billion a decade earlier.

GE's operating profit contracted to $9.2 billion, down from $11.5 billion in 2013. In that context, it is also worth noting that GE doesn't really invest in R&D, although operating in industries where technology is important. This competitive pressure poses an ongoing challenge. For TTM, GE invested only about 3.6% of revenues in R&D. This is down from 3.9% of R&D in 2016.

Readers will surely point out that my analysis so far is backward looking. And the stock market is all about the future. This is correct. But it still won't change the picture for GE. Looking at the next five years, GE is not really expected to grow earnings. In fact, analyst consensus sees about 3.6% CAGR in EPS through 2027. Accounting for the well-established knowledge that analyst consensus is tendentially too optimistic about earnings growth, GE's "true" growth prospects on EPS should be closer to 0% CAGR.

Now, even if we accept an analyst consensus as a correct projection of GE's growth outlook, the company's stock still looks grossly overvalued at a $116 billion market capitalization. To underscore the point, below I structured a residual earnings model based on ...

• analyst consensus estimates through 2027,
• a cost of equity of 10.3%, in line with the CAPM model,
• and, a terminal growth rate of 2.25, in line with the growth outlook of the broader global economy.

These assumptions suggest that GE stock should be valued closer to $71.62/ share, implying almost 30% downside.

I understand that investors may have different assumptions on GE's terminal growth and implied cost of equity. But the story to justify GE's valuation still is very difficult: the math would need a terminal growth CAGR of close to 4%, paired with a cost of equity below 10%.

(column = growth rate; rows = implied cost of equity).

Investor Takeaway

In summary, General Electric grapples with a challenging and prolonged transformation, which benefits must yet to be proven. Over the past decade, GE's revenues have declined, profitability has eroded, and R&D investment lags in tech-driven industries. The upcoming spinoff of GE Vernova adds a layer of uncertainty, while GE Aerospace faces cyclical pressures and recent supply chain challenges.

Despite recent stock gains, the long-term historicals and outlook appear bleak. Analysts project limited earnings growth through 2027. In this restructuring story, GE remains a value trap with potentially 30% share price downside. I advise to avoid until GE stock until GE can prove sustainable and high-quality earnings growth.