April 06, 2015
Founder of IOI Investor Services, LLC and Author of The Intelligent Option Investor
Valuation Report and Option Strategy - General Electric (GE)
The attached report provides a thorough, transparent valuation of what we believe is a compelling investment opportunity--$GE--as well as offering a perspective on several levered investment strategies using listed or listed look-alike option contracts. This report was originally published in January 2015, but pricing remains roughly the same at present and we reiterate our recommendation.
GENERAL ELECTRIC
(GE)
5
JANUARY
2015
Bullish, Large
-
Cap, Transition, Ind
ustrial, Energy, Medical
TABLE
OF CONTENTS
Contents
Valuation & Strategy Overview
________________________________
__________________
1
Investment Thesis
________________________________
________________________________
_______
1
Business
________________________________
________________________________
______________
1
Market
________________________________
________________________________
______________
1
Mispricing
________________________________
________________________________
____________
1
Valuation Range vs. Option Market Price Range
________________________________
_________
3
Valuation Scenarios
________________________________
________________________________
____
4
Option Strategies
________________________________
________________________________
_______
5
Leverage
________________________________
________________________________
______________
7
Company Summary
________________________________
____________________________
8
GE Made Simple
________________________________
________________________________
_______
8
Why Not Get Rid of GE Capital Altogether?
________________________________
_____________
10
Valuation Driver Analysis
________________________________
_______________________
13
Revenues
________________________________
________________________________
_____________
13
Profits
________________________________
________________________________
_________________
17
Investment Level
________________________________
________________________________
______
20
Investment Composition
________________________________
_______________________________
22
Free Cash Flow to Owners
________________________________
______________________________
23
Investment Efficacy
________________________________
________________________________
____
25
Balance Sheet Effects
________________________________
________________________________
_
26
Valuation Scenarios
________________________________
____________________________
28
Revenue Best
-
and Worst Case
________________________________
_________________________
28
Profitability Best
-
and Worst
-
Case
________________________________
_______________________
32
Investment Level
________________________________
________________________________
______
33
Free Cash Flow to Owners
________________________________
______________________________
34
Medium
-
Term Best
-
And Worst
-
Case Growth
________________________________
____________
34
Long
-
Term Growth
________________________________
________________________________
_____
35
TABLE
OF CONTENTS
Valuation Scenarios
________________________________
________________________________
___
36
Valuation Scenarios Narrative
________________________________
__________________________
37
Investment Strategy
________________________________
____________________________
39
Investment Structure
________________________________
________________________________
___
39
Alternate Structure
________________________________
________________________________
____
41
Leverage
________________________________
________________________________
_____________
43
Market Risk
________________________________
________________________________
____________
46
Notes
________________________________
________________________________
_________
48
Appendixes
________________________________
________________________________
___
49
Appendix 1: Reading IOI Charts and Tables
________________________________
_____________
49
Valuation vs. Option Market Graph
________________________________
___________________
49
Valuation vs. Stock Market Graph
________________________________
____________________
51
Valuation vs. Market Table
________________________________
___________________________
52
Glossary
________________________________
________________________________
______________
52
Owners
’
Cash Profits
________________________________
________________________________
_
52
Expansionary Cash Flow
________________________________
_____________________________
55
Free Cash Flow to Owners (FCFO) and Assessing Investing Efficacy
_____________________
58
IOI Contact Information
________________________________
________________________
59
VALUATION & STRATEGY
OVERVIEW
Page
1
Valuation & Strategy Overview
INVESTMENT THESIS
Business
Industrial and Technological segments a
re positioned to meet demand for essential
infrastructure and products in both developed and developing markets.
GE holds m
arket leading positions in its
target
markets
and has a large intangible asset
in the form of intellectual property and government co
nnections
.
The General Electric Capital Corp. (GECC) has transitioned back to one focusing on
commercial lending and equipment leasing. This has reduced the risks characterized
by its consumer
-
finance during the financial crisis.
GECC functions both as a b
usiness intelligence
-
gathering arm and, through complex
off
-
shore arrangements,
as an enormously effective tax management tool.
Industrial and High
-
Tech r
evenues
have grown at roughly 2% per year over the past five
years and profits at roughly 3%.
Market
G
E
’
s market price is affected by its exposure to technology (via its Healthcare segment)
and to the price of oil (via its Oil & Gas segment). Bad news in the NASDAQ market and
in the spot price of crude tends to drive GE
’
s price down.
Over half of GE
’
s reve
nues are generated overseas. GE
’
s earnings will be affected by
forex fluctuations, and will be hurt by a strong dollar. GE
’
s policy is to reinvest overseas
profits overseas (to avoid tax on repatriation of overseas profits), so we view any GE
weakness due
to currency effects as non
-
material to the valuation long
-
term.
Mispricing
The market likely
assesses
a conglomerate haircut
on
GE since its business is perceived
to be complex. We believe its business is simple, but acknowledge complexity in its tax
avoid
ance
structures
and that acquisition activity makes understanding growth rates
more difficult
.
The market is likely anchoring on declining revenues and profits (both of which have
been affected by divestment of consumer finance business) and is mistakenly
extrapolating these recent trends as structural, rather than temporal features of GE
’
s
business.
The market may be pricing in a fairly high chance of a severe worldwide economic
slowdown that we have not included in our valuation scenarios. Our worst
-
case
revenue scenario sees average revenue growth over the next five years of 1%, followed
by medium
-
term (years 6
-
10 of our forecast) profit growth averaging 5% per year.
VALUATION & STRATEGY
O
VERVIEW
Page
2
Our forecast hinges on GE
’
s
medium
-
and long
-
term profit growth returning to at least
the
5% per year level, so is a
“
return towards the mean
”
investment argument.
VALUATION & STRATEGY
OVERVIEW
Page
3
VALUATION RANGE VS.
OPTION MARKET PRICE
RANGE
Worst
-
case valuation implies little downside investment risk
WORST
CASE
LIKELY
CASE
BEST
CASE
Market (Price)
$
20.50
$
26.00
$
34.00
IOI (Value)
1
$
28.00
$
36.00
44.00
Difference
$
7.50
$
10.00
$
10.00
Implied Return (%)
4.5
34.3
53.9
Summary
Option market is fundamentally missing the valuation of GE, making its downside exposure and
upside exposure undervalued.
Implied
likely
worst
-
cas
e return is slightly positive
.
1
Shows the worst
-
and best
-
case scenarios IOI
’
s analysis considers most likely. Likely case is an
average of these two values.
VALUATION & STRATEGY
OVERVIEW
Page
4
VALUATION SCENARIO
S
Case / Scenario
Value
PSR Implied Low
15
252
-
day Low
24
1% | 12% | 5%
26
*
1% | 12% | 7%
28
252
-
day High
28
5% | 12% | 5%
30
5% | 12% | 7%
32
1% | 17% | 5%
39
1% | 17% | 7%
42
PSR
Implied High
44
*
5% | 17% | 5%
45
5% | 17% | 7%
48
N
OTES TO
T
ABULAR
D
ISPLAY
Valuation Scenarios
1%
|
12%
|
5%
Avg. Revenue Growth =
1%
Avg. OCP =
12%
Avg. Med.
-
Term Growth =
5%
Scenarios marked with an as
terisk are IOI most
-
likely worst
-
and best
-
case scenarios. Gray values deemed
economically invalid.
PSR Implied Low
price multiplies IOI
’
s average worst
-
case
revenues for explicit valuation period by the 1
st
decile
cutoff value for historical price
-
to
-
sale
s ratio.
PSR Implied
High
price multiplies IOI
’
s average best
-
case revenues
during explicit valuation period by the 9
th
decile cutoff
value for historical price
-
to
-
sales ratio.
Curve indicates probability
distribution as estimated by the
option market
VALUATION & STRATEGY
OVERVIEW
Page
5
OPTION STRATEG
IES
In
-
the
-
Money call options and a long stock position form the core of IOI
’
s preferred investment
structure
IOI
’
s preferred
structure combines
In
-
the
-
Money (ITM) call options as s
hown above
with a long
position in the stock and the maintenance of a cash reserve
. This strategy represents a high
conviction, moderately levered alternative to straight ownership of stock.
A higher
-
leverage alternative is the purchase of Out
-
of
-
the
-
Money
(OTM) call options. A lower
-
leverage alternative is the sale of ATM put options. These alternatives
are depicted below and
can be combined
as a
“
Diagonal
”
(see p. 36)
.
VALUATION & STRATEGY
OVERVIEW
Page
6
VALUATION & STRATEGY
OVERVIEW
Page
7
LEVERAGE
A
hybrid position, containing cash
(17%)
, call options
(33%)
, and st
ock
(50%)
generates an IOI
leverage factor of
-
1.1 / 1.5.
Using the IOI most
-
likely fair value (FV) estimate, IOI Leverage and
returns for levered and unlevered strategies are as follows:
Assuming a 5% allocation of capital to the GE investment, an inves
tor would buy two ITM call
contracts struck at $18.00 and 95 shares for every $100,000 in portfolio value.
FAIR VALUE ESTIMATE
36
Shares Bought (#)
95
Call Contracts Bought (#)
2
Mkt Value of Shares
2,497.55
Mkt Value of Options
1,668.00
Cash in Reser
ve
834.45
Capital at Risk
4,165.55
This allocation generates the following leverage diagrams:
An unrealized loss on the stock and option
positions occur between the average
purchase price and the strike price.
Loss of option premium occurs if the opti
on
expires below the strike price of
$
18
.
Downside exposure is partially ameliorated
by the cash position.
This diagram compares the hybrid position
described in the table above to a full
allocation of straight
-
stock.
The hybrid investor is benefited
if the stock
rises above the average buy price, is
relatively worse off, if the stock price at
expiration is between $9 and $18, and is
relatively better off if the option expires
when the stock trades below $9.
IOI Leverage
-1.1 / 1.5
Strategy Return at FV
57%
Unlevered Return at FV
37%
COMPANY SUMMARY
Page
8
Company
Summary
When the Sage of Omaha anno
unced that his Berkshire Hathaway would buy
$
3
billion worth
of General Electric
’
s preferred shares after the Lehman Shock of
2008
, Buffett was quoted as
saying that GE was
“
the symbol
”
of American business.
Indeed, GE is so symbolic of American business,
it is almost a caricature of it. Its transformation
from a pioneer in electrical power and radio in the early twentieth century to an ungainly
conglomerate in the post
-
War boom years, to a scientifically managed bureaucracy in the
post
-
Nixon years, to a wh
eeling
-
dealing quasi
-
hedge fund run by a celebrity manager from the
1980
s through the turn of the twenty
-
first century, mirror the ascendency of the U.S. economic
empire.
Chastened and refocused after a brush with financial disaster post
-
Lehman, the direct
ion GE is
heading may speak to the future of the U.S. economic empire as well.
GE MADE SIMPLE
You may think that GE is a phenomenally complex firm, but you are mistaken.
Thanks to the successes and failures of GE
’
s prior and present CEOs, the company is bu
sily and
successfully concentrating its resources to profit from only two main economic bets:
1.
The aging, developed world requires the power and technologies to maintain its
standard of living.
2.
The young, developing world requires the power and infrastruct
ure to develop.
GE
’
s segments, and the classification we will use in this report to describe their foci, is as follows:
Segment
Classification
Power & Water
2
Commercial Inputs
Oil and Gas
Commercial Inputs
Energy
Management
Commercial High
Tech
Aviati
on
Commercial High
Tech
Healthcare
Commercial High
Tech
2
Most of the
“
water
”
part of this segment should be read as
“
hydroelectric power
”,
though
there
is a bit of infrastructure water
—
desalinization, wastewater treatment, pumps,
valves, etc.
COMPANY SUMMARY
Page
9
Transportation
Commercial High
Tech
Appliances &
Lighting
Consumer Products
GE Capital
Consumer Services
Commercial Services
Each of the segments listed as Commercial are those that do not sell t
o an individual, but
rather to a state or corporation. Any segment listed as
“
Inputs
”
are those mainly involved in the
conversion of an energy input into usable power. Any segment listed as
“
High Tech
”
involves
highly engineered products and protected inte
llectual property.
“
Services
”
include financial
services and the entertainment services of NBC.
Appliances & Lighting (making up only about
5%
of the company
’
s revenues), will soon be sold
off, as will the Consumer Services piece of GE Capital.
If you are
thinking that GE Capital does not fit well into the framework of Power / Technology /
Infrastructure, you are right. That division holds a special role, which we discuss below.
The following graph estimates the value of the 45 major acquisitions the compa
ny has made
since 2004, sorted into the above classification scheme.
3
3
Not all of the sale or purchase amounts were made public, so these figures are estimates.
Directionally, we believe them to be representative of the company
’
s investment activity.
Commercial High Tech
Commercial Inputs
Commercial Services
Consumer Products
Consumer Services
(60,000)
(50,000)
(40,000)
(30,000)
(20,000)
(10,000)
-
10,000
20,000
30,000
40,000
Estimated Aggregate Amounts (2003-2015e)
Aggregate Net Cash Flows from Divestitures (Capital Expenditures)
COMPANY SUMMARY
Page
10
Figure 1. Source: Company Statements,
IOI
Analysis
In this graph, a positive number means a net cash inflow from a divestment; a negative
number shows a net cash outflow from a capital
expense. Note that the aggregate
divestments are all classified as
“
Consumer
”
and that the aggregate capital expenditures are
all classified as
“
Commercial.
”
The story, told in a time series graph, is interesting as well:
Figure 2
. Source: Company Sta
tements,
IOI
Analysis
Note that pre
-
financial crisis, the firm was continuing to spend cash on Consumer Services
(both financial services and entertainment assets). However, since the financial crisis, there was
only one net capital expenditure for Consume
r
-
related categories, and that was actually
related to the eventual divestment of NBC.
The shift in GE
’
s focus is clear: Move away from the end customer. Move closer to the provision
of power, major infrastructure, and technologies used by large organizati
ons.
WHY NOT GET RID OF G
E CAPITAL ALTOGETHER
?
GE Capital and its subsidiaries (including a sub
-
prime mortgage broker that submitted
fraudulent paperwork on behalf of borrowers in somewhere around 75%
-
80% of cases) almost
(30,000)
(20,000)
(10,000)
-
10,000
20,000
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014e
2015e
Estimated Net Cash Flow from Divesitures (Acquisitions)
Commercial High Tech
Commercial Inputs
Commercial Services
Consumer Products
Consumer Services
COMPANY SUMMARY
Page
11
sank the ship during the financial
crisis and is responsible for GE losing its coveted AAA bond
rating in
2009
. Why not divest it and focus on the economic bets mentioned above?
The answer is simple: The U.S. Tax Code.
Unless the power brokers on Washington D.C.
’
s K Street
4
decide they hav
e
“
helped
”
their
nation enough and voluntarily shut their doors, leading to major structural change in the U.S.
tax code, GE Capital will remain an integral profit center for the firm
—
not because its business
has a high return on assets (it doesn
’
t), but b
ecause it allows the rest of GE to avoid paying so
much in taxes.
Immelt is most certainly breathing a big sigh of relief now that he knows he will get the monkey
of U.S. consumer lending off his back (as he has already done in Europe, Latin America, and
A
sia), but the Commercial Lending business will never go.
The details are not pretty, but as far as this author can tell, all true and (until proven otherwise in
a court of law) consistent with present IRS regulations and court rulings.
GE has set up a comp
lex web of wholly
-
owned subsidiaries, partnerships, Cayman Island
registered LLCs, and difficult
-
to
-
track business arrangements which allows it to engage in
“
transfer pricing
”
and other schemes which result in it recording very low tax expenses and
—
as
long
as the firm does not repatriate funds from overseas
—
paying even less taxes than it
records.
The recent agreement to purchase French power generating equipment giant Alstom ($17
billion, listed in Figure 2 above as an estimated outflow in 2015) is
—
while be
ing in line with GE
’
s
refocused Power / Technology / Infrastructure strategy
—
almost certainly motivated in part by
the desire to make sure that portion of the firm
’
s overseas cash hoard will never be taxed.
It is telling that before Jack Welch became CEO,
financing revenues counted for a miniscule
portion of GE
’
s revenues and profits (somewhere around 0.005% of total revenues in 1978). One
of the first strategic moves that Welch made upon becoming CEO was starting to buy industrial
equipment as the core of
its consumer leasing business. Over the years, Welch realized that
financial transactions were handy in smoothing profits, and in his turn, Immelt became
enamored with the brisk growth rates in the mortgage lending business.
The degree to which earnings a
re
“
managed
”
may have decreased since Welch
’
s heyday,
and the stagnating earnings power and simultaneous deleveraging of the American middle
4
K Street is famous for being the location of all the high
-
p
ower political lobbying firms.
COMPANY SUMMARY
Page
12
class makes consumer credit less appealing, even if GE had not had such a close call during
the mortgage crisis. Th
at said, considering the tax benefits alone, GE Capital
’
s business is
essential for the company
’
s
continued profitability levels.
VALUATION DRIVER ANA
LYSIS
Page
1
3
Valuation Driver Analysis
REVENUES
GE Capital divestments have more than offset
recent
tepid growth in Industrial and Technolo
gy
segments. PIT Strategy leaves GE well
-
positioned for growth proportion
al
to global economic
vigor
.
Figure 3. Source: Company statements, IOI Analysis
Segment
-
level revenue contribution shows that GE Capital Corp. (GECC) as the largest single
source of
revenues. After several years of divestments, GECC is now a wholly commercial
-
facing enterprise focused on equipment leasing and inventory funding.
Roughly 37% of revenues were generated from industrial, infrastructure
-
focused businesses
(Power & Water, O
il & Gas, Energy Management, and Transportation). These businesses
’
revenue sources are drawn from both developing and developed economies.
The remaining part fits under the heading of high
-
tech. Aviation and Healthcare together
make up roughly 27% of reve
nues, and these revenue sources are mainly from developed
economies
The purchase of Alstom will end up making the industrial portions a bit larger in terms of
revenue share than the high
-
tech or financing pieces, but in general, it is helpful to think of
GE
Power & Water
17%
Oil & Gas
11%
Energy
Management
5%
Aviation
15%
Healthcare
12%
Transportation
4%
Appliances &
Lighting
6%
GE Capital
30%
2013 Revenue Contribution
VALUATION DRIVER ANA
LYSIS
Page
14
as a tripod resting on the legs of Infrastructure,
Commercial Financing and Lending
,
and
High
-
Tech
.
Figure
4
. Source: Company statements, IOI Analysis
2009
2010
2011
2012
2013
Power & Water
-
4.0%
-
9.5%
3.6%
10.2%
-
12.6%
5
Oil & Gas
-
2.1%
-
2.6%
44.3%
6
12.0%
11.4%
7
Energy Management
-
18.7%
-
1.2%
24.4%
15.4%
2.1%
Aviation
-
2.7%
-
5.9%
7.0%
6.0%
9.6%
Healthcare
-
7.9%
5.5%
7.0%
1.1%
-
0.5%
Transportation
-
23.7%
-
11.9%
45.0%
14.8%
4.9%
5
From the 2013 MD&A:
“
Power & Water (18% and 23% of consolidated three
-
year revenues
and total segment profit, respectively) revenues decreased 13% in 2013 primarily as a result of
lower volume and the effects of the stronge
r U.S. dollar, partially offset by higher prices and
other income. Revenues increased
10%
in
2012
primarily as higher volume and other income
were partially offset by the effects of the stronger U.S. dollar and lower prices.
”
6
Oil & Gas, Power & Water, an
d Energy Management was all lumped together into a single
segment called Energy Infrastructure. MD&A commentary for 2011 for this segment is as follows:
“
Energy Infrastructure (27% and 39% of consolidated three
-
year revenues and total segment
profit, respe
ctively) revenues increased 16% in 2011 primarily as a result of acquisitions during
2011 and higher volume due to increased sales of services at Energy and Oil & Gas, after
decreasing 8% in 2010 as the worldwide demand for new sources of power, such as wi
nd and
thermal declined with the overall economic conditions.
”
7
2012
increase boosted by acquisitions.
2013
increase due to higher volume and stronger
pricing.
Power & Water
Oil & Gas
Energy Management
Aviation
Healthcare
Transportation
-30%
-20%
-10%
0%
10%
20%
30%
40%
50%
2009
2010
2011
2012
2013
GE Segment Revenue Growth Rates
VALUATION DRIVER ANA
LYSIS
Page
15
Alstom will fit into the Energy Management segment All of Alstom gr
ew at an average rate of
0.6%
over this time, though not all of Alstom
’
s revenues will be owned by GE shareholders.
The
five
-
year compound annual
growth rate of
GE
’
s industrial and high
-
tech segments (ex
-
Appliances & Lighting and GE Capital, which are also
not shown above) has been
1.9
%
(base
year of 2008)
.
The GE Capital
revenue
CAGR during this time has been strongly negative (
-
8.5%
per year) due
to divestitures.
The relative revenue share and 5
-
year CAGR of each
industrial
segment is represented in the
h
eat map in Figure
5
, below.
Figure
5
. Source: Company statements, IOI Analysis
Here, the FY2013 segment revenue
(in billions USD)
is shown below the segment name; below
that is the 5
-
year CAGR. Box size represents revenue share; box color represents reve
nue
growth rates.
On an aggregate basis, revenues at GE over the past
10
years have looked like this:
VALUATION DRIVER ANA
LYSIS
Page
16
Figure
6
. Source: Company statements, IOI Analysis
GE
’
s rapid revenue growth in the mid
-
2000s was in part thanks to strong industrial demand, but
also i
n part to rapid growth of GE
’
s consumer finance business, including its presence in the
sub
-
prime
mortgage
origination and
securitization market.
Since GE lost its AAA bond rating as
a result of the uncertainties associated with consumer lending in 2009, t
he company has
divested each of its consumer lending business worldwide. These divestments have more than
offset the generally positive revenue growth in the industrial segments.
Consumer finance divestments are now complete, leaving GECC with only commerc
ial facing
business
—
equipment leasing, inventory financing, etc.
With divestments complete, GE
’
s future
revenue growth will be governed by economic growth in the industrial sector and future
acquired revenues.
VALUATION DRIVER ANA
LYSIS
Page
17
PROFITS
Divestment
-
related charges and divest
ment of profitable businesses has caused GE
’
s profits to
shrink. Profitability in remaining businesses is high
and fairly stable, implying a post
-
divestment
rebound in profits and margins.
Figure
7
. Source: Company statements, IOI Analysis
It is tempting
to assume that GECC has the highest margins of any of GE
’
s segments, but in
fact, its profitability is not even in the top three segments, as we can see in the table below.
SEGMENT
FY
13
EBIT
MARGIN
Power & Water
20%
Aviation
20%
Transportation
20%
GE
Capital Segment
19%
Healthcare
17%
Oil & Gas
13%
Appliances & Lighting
5%
Energy Management
1%
Industrial Segments
15%
Industrial Segments (ex
-
Appl
iances
)
17%
However, while GECC
’
s explicit profitability is not at the top of the list in terms of EB
IT margins, its
tax structures allow for much greater proportions of all segments
’
operational profitability to fall
through to shareholders.
Power & Water
20%
Oil & Gas
9%
Energy
Management
0%
Aviation
18%
Healthcare
12%
Transportation
5%
Appliances &
Lighting
2%
GE Capital
Segment
34%
2013 EBIT Contribution
VALUATION DRIVER ANA
LY
SIS
Page
18
Margins tend to be stable over time, as we can see in the following table:
SEGMENT
-
LEVEL EBIT
MARGIN
2009
2010
20
11
2012
2013
Power & Water
20%
23%
20%
19%
20%
Aviation
21%
19%
19%
19%
20%
Transportation
12%
9%
15%
18%
20%
Healthcare
15%
16%
16%
16%
17%
Oil & Gas
15%
15%
12%
13%
13%
Appliances & Lighting
5%
5%
3%
4%
5%
Energy Management
3%
3%
1%
2%
1%
Industrial Segments
16%
16%
14%
15%
15%
GE Capital
Corp.
3%
6%
13%
16%
19%
Of the industrial segments, the one with the
greatest year
-
to
-
year operational profit
variability is
obviously Transportation.
This variability is due to operational leverage, a
s can be
deduced
from the
following chart and the fact that t
here is a 99.4% correlation between
revenue
change and profits change over this time period.
Figure
8
. Source: Company statements, IOI Analysis
If we look at five
-
year EBIT CAGR for all industr
ial segments (ex
-
Appliances and Lighting), we
see that growth is 3% per annum since 2008. Comparing this to the five
-
year revenue CAGR
(
2
%
), we can see that over this period, GE has increased profits roughly 50% faster than it has
increased revenues; as su
ch, building in some degree of operational leverage into our
valuation model seems sensible.
-40%
0%
40%
80%
120%
160%
-
1,000
2,000
3,000
4,000
5,000
6,000
2009
2010
2011
2012
2013
GE Transportation Segment
Profits
Revenues
Profits Change
Revenue Change
VALUATION DRIVER ANA
LYSIS
Page
19
Looking at
aggregate
Owners
’
Cash Profits, we can
see
th
at a combination of divestments
and charges taken as a result of these divestments
8
have eaten into
OCP an
d OCP margin
(see graph on next page).
Figure
9
. Source: Company statements, IOI Analysis
The decline in OCP looks shocking, but when we look at Free Cash Flow to Owners in a few
pages, the picture will make more sense.
8
GE had to unwind hedges associated with the consumer finance business. The unwinding of
these
hedges have generated a non
-
cash profit that is backed out on the Statement of Cash
Flows, leading to lower OCP, a cash
-
centric profitability metric.
VALUATION DRIVER ANA
LYSIS
Page
20
INVESTMENT LEVEL
The divestmen
t program mentioned earlier is clearly visible in the following graph.
Figure
10
. Source: Company statements, IOI Analysis
While the ability to compare financial metrics over long periods decreases the longer the
period becomes, in this case, it
’
s instru
ctive to look at the level of
GE
’
s expansionary spending
over a longer time period. Figure 11 shows the data for GE over the past 30 years.
VALUATION DRIVER ANA
LYSIS
Page
21
Figure
11
. Source: Company statements, IOI Analysis
Clearly, the most recent period has been affected by the prog
ram of net divestitures
—
the
average Net ECF % OCP of
-
23% during this period shows that program clearly
. Before that, the
company had embarked on a very large net acquisition program
, where the average
expansionary spending was over three
-
fourths of OCP
. T
hroughout the 1990s, the
cash flow
spent on expansionary investments was in the mid
-
teens. Considering that the long
-
term
average is close to the 1990s period, we would venture to say that a best
-
guess level would be
in that one
-
fifth of profits range.
1990
-
1998 Average
,
14%
1999
-
2005 Average
,
76%
Post
-
2006 Average
,
-
23%
Overall Average
,
20%
-150%
-100%
-50%
0%
50%
100%
150%
1990
1995
2000
2005
2010
Net Expansionary Cash Flow as a Percent of Owners' Cash Profits
VALUATION DRIVER ANA
LYSIS
Page
22
I
NVESTMENT COMPOSITIO
N
The firm spends most of one quarter
’
s worth of buybacks on soaking up stock compensation
-
based
dilution.
Recent divestments have more than offset acquisitions supporting the PIT
Strategy.
Figure
12
. Source: Company statements, IOI A
nalysis
Again, the divestment program affects our view of investment composition, but Figure
12
shows the composition of GE
’
s investment/divestment program over the past
10
years.
The firm spends an average of around $1.5 billion per year soaking up dilut
ion from to stock
-
based compensation before it starts in on its buyback program proper.
The firm spends roughly
$
2 billion per quarter on its buyback program, implying that most of one quarter
’
s buybacks
are simply soaking up dilution and the other three q
uarters plus are actually concentrating
present owners
’
stakes.
VALUATION DRIVER A
NALYSIS
Page
23
FREE CASH FLOW TO OW
NERS
GE has been
“
buying
”
higher cash flows for its owners by
“
selling
”
profits.
Figure
13
. Source: Company statements, IOI Analysis
Above, we saw that GE
’
s profits and
profitability had been on a decline as it divested more
and more of its consumer
-
facing businesses. If we look now at FCFO, we see that, in a sense,
GE has been selling profits in exchange for higher cash flows to owners.
Notice that FY2013 FCFO margin is
at a 10
-
year high and, with the exception of 2008, when the
firm issued new shares to boost liquidity
9
, FCFO margin has been materially higher than the
post
-
mortgage melt
-
down peak level.
9
We assume that any issued shares will be bought back eventually in order to limit the effects
of diluti
on on EPS, and further assume that this can be thought of as an
“
investment
”
of owners
’
profits. As such, we deduct an estimate of the amount it will take to buy back the issued shares.
VALUATION DRIVER ANA
LYSIS
Page
24
It would be unreasonable to assume that the company can continue a
program of net
divestments in perpetuity, so of course, we should not expect FCFO to be as high as the most
recent levels going forward.
The divestment of consumer finance businesses and the cash inflow from these sales have
contributed to a deleveraging o
f GE
’
s balance sheet, as we can see in figure
13
, below.
Figure
13
. Source: Company statements, IOI Analysis
Both GE
’
s leverage ratio and Debt
-
to
-
Equity ratio are at generational lows, despite the
company
’
s continuing share buyback program
—
a factor that
has the effect of increasing
leverage.
We have assumed a $15 billion charge this year, and if we were to add
back that amount to
the
2008
figure, we can see that the firm would have generated roughly
$
25
billion in FCFO.
0
2
4
6
8
10
12
1990
1995
2000
2005
2010
GE Financial Leverage Metrics
Leverage Ratio (Total Assets / SE)
Debt / Equity
VALUATION DRIVER ANA
LYSIS
Page
25
INVESTMENT EFFICACY
The firm
’
s profits have grown slower than the economy at large in the past due to the dynamics
discussed above, but future investment efficacy is likely to be higher.
Figure
1
4
. Source: Company
statements, IOI Analysis
We look at investment efficacy in terms of how quickly the firm is able to expand its profits vis
-
à
-
vis nominal GDP. The light blue columns in figure 14 represent the OCP the firm would have
generated were it to have invested well
enough to expand its profits at the same rate as the
economy at large. Dark blue columns represent the profits actually achieved by the company.
Here, we see that due to divestments already discussed, GE
’
s investment efficacy appears low
versus the econom
y at large, and we posit that this may have a lot to do with the stock
’
s
relative
underperformance to the S&P 500 over this time period.
VALUATION DRIVER ANA
LYSIS
Page
26
Figure
1
5
.
Source:
Google Finance
The view of investing efficacy shown in figure 14 is entirely backward looking, but thinkin
g
about GE
’
s product portfolio and its PIT strategy, it is hard to see how GE
’
s profits going forward
would lag notional GDP, and, assuming that demand for infrastructure build outs in emerging
markets and for energy worldwide will be relatively faster gro
wth areas, it is likely that GE
’
s
investment efficacy in the future will be much better than it has in the recent past.
This implies that medium
-
term FCFO growth rates should be above trend vis
-
à
-
vis domestic U.S.
nominal GDP.
BALANCE SHEET EFFECT
S
FACTOR
POSITIVE /
NEGATIVE
NOTES
Intellectual Property
Positive
GE has been awarded an enormous number of
patents over its economic life, and ranks behind only
IBM in terms of total patents granted. The number of
patents it is granted in any year usually places
it within
the top 10 or top 20 companies in the world. IP is one
source of economic moat, and the fact that GE is so
active in this are indicates that it is actively maintaining
and expanding its competitive and commercial
advantage.
Competitive
Position
Positive
Welch
’
s legacy of selling of losers (defined as bronze
medal or below) has meant that GE
’
s present portfolio
is extremely competitive. Welch
’
s long tenure has
inculcated this business strategy into
the company
culture, and it is one of the definin
g features of GE
strategy. Difficult to put a numeric value on the worth
of this, but its strong competitive position in businesses
with compelling moats (technological, network
VALUATION DRIVER ANA
LYSIS
Page
27
effects, government access, etc.) reduces this firm
’
s
overall valuation risk.
Reputation
Positive
Another factor for which a numeric value is difficult to
estimate. The firm does, however, attract top talent
from top institutions world
-
wide and is known for the
strength of its training and development program. In a
phrase, the man
agement bench at GE is deep, and
this is undoubtedly a positive during times of crisis.
Nuclear Exposure
Negative
GE Mark I reactors damaged in the Fukushima disaster.
Two class action law
suits in NY Supreme Court right
now
and potential liability estimates are in the $300
billion range. High impact, low probability event. GE
likely shielded by U.S. and Japanese governments,
which could also be plausibly considered to be
complicit (approva
l of designs). Court case and
appeals likely to take at least a generation. This case
represents but one of thousands of cases in which GE is
subject to potential liability due to its nuclear energy
portfolio.
Tax Management
Schemes
Negative
A material am
ount of GE
’
s FCFO is directly attributable
to its aggressive, sophisticated tax management
structures. Considering the amount of money spent on
lobbying by GE and other industry groups, it is, in this
author
’
s opinion, unlikely that the government will tak
e
action that would seriously affect this
“
source
”
of cash
inflow, but again, it is a situation of high impact / low
probability negative event.
Conglomerate
Effect
Negative
GE is a phenomenally complex entity to attempt to
understand from a reductionist
approach. This
complexity breeds suspicion and likely, some
perceived discount in its value from its theoretical fair
value estimate.
Immelt is widely seen as a poor
manager by some investors, but considering that his
tenure began four days before the 9/1
1 attacks and
that he was also CEO during the most dramatic fall in
global economic activity since the Great Depression
makes this observer think that he has been unfairly
assessed. These strong negative feelings may be part
of the reason why GE looks like
such an attractively
valued security at present.
VALUATION SCENARIOS
Page
2
8
Valuation Scenarios
IOI valuations use a three
-
stage discounted cash flow model. Explicit projections for revenues,
profitability, and investment level govern the cash flow estimates for stage 1 of our m
odel (the
Explicit Stage). Projections for medium
-
term growth rates are based on our analysis of likely
investment efficacy and affect stage 2 of our model (the Investment Stage). We call stage 3
the
“
Terminal Growth Stage
”
and peg the growth of the firm
’
s
FCFO to the growth of nominal
GDP (which we estimate to be 5% per annum in perpetuity). This method has good academic
support from the work of Chan and Lakonishok.
REVENUE BEST
-
AND WORST CASE
Looking back at
five
-
year revenue growth rates for the industr
ial sectors, we see a low single
-
digit percentage increase since 2008
10
. Thinking about demand in
each of the three main
business lines, we have:
BUSINESS LINE
LIKELY
GROWTH
RATE
FACTORS AND DEPENDEN
CIES
Technology
GDP+
Healthcare constrained by payment sy
stem, so
fiscal shortfalls may serve as a headwind. This
headwind may be partially or fully offset by
demographic tailwind in the developing
economies. Aviation
and Transportation
demand
correlated to global economic output and need
for shipping and busine
ss travel. Pressure on air
and rail
carriers to save on fuel costs prompts
upgrade demand for components with fuel
efficient technology.
Infrastructure / Power
GDP+
Developing economies
’
demand for
energy
infrastructure suggests growth at greater than
U.S
. domestic GDP levels. Developed economies
’
focus on greater energy and transmission
efficiency and suggests demand for smart grid
technology and other products and services in
GE
’
s list of core competencies. Demand for oil
and gas is closely correlated to
economic
growth, but can be volatile over the short
-
term,
due to geopolitical and other considerations.
10
Note that this revenue CAGR is uncorrected for mergers and acquisitions.
VALUATION SCENARIOS
Page
29
GECC
GDP++
Equipment leasing business should be closely tied
to overall economic activity and industrial
demand. Inventory and working capital
financi
ng services
are more scalable, but this
scaling comes at the expense of exposure to
financial leverage.
VALUATION SCENARIOS
Page
30
Considering these drivers, we use the following best
-
and worst
-
case revenue growth
assumptions
:
Best case
: Forward five
-
year CAGR of
4.6%
Worst cas
e
: Forward five
-
year CAGR of
1.2%
Graphically, these assumptions are represented in figure
16
.
Figure 16. Source: Company Statements, IOI Analysis
We use analyst consensus high
-
and low
-
estimates for 2014 revenue for best
-
and worst
-
case
scenarios in th
at year. Remaining years are modeled using straight
-
line assumptions of
5%
and
1%
, respectively.
Representative Best
-
Case Scenario
: U.S. builds on and deepens the present economic
recovery, median incomes rise, and economic activity becomes more robust. Eu
ropean
economies pull out of the present recession / near recession.
Healthcare budgets in Europe
and the U.S. are not negatively affected by austerity programs. Infrastructure programs
—
VALUATION SCENARIOS
Page
31
especially those related to power generation
—
in the Middle East and Af
rica expand as
tensions in the Maghreb and Sub
-
Saharan Africa subside. China continues to successfully
negotiate a soft
-
landing, and other Asian economies, boosted by export revenues, increase
demand for infrastructure, medical, and transportation technolo
gies. Oil and natural gas prices
rise moderately, encouraging more exploration and drilling projects in the U.S. and overseas.
GECC revenues grow somewhat faster than the economy at large.
Representative Worst
-
Case Scenario
: The U.S. recovery stalls as the
Fed raises rates; median
incomes continue to stagnate and spending remains modest. In response, companies cut
back on capital expansion plans. Smart grid projects and other major generation and
transmission projects in the U.S. are postponed due to fiscal
weakness among municipalities.
Europe returns to recession and this recession is relatively
deep and
long
-
lasting
(though not
enough to cause a global crisis a la 2008)
. Austerity programs cut into state
-
funded healthcare
spending, reducing demand for GE
’
s products and services.
Depressed economic activity in
the OECD countries has a knock
-
on effect on developing economies, as export markets
slow
down. Reduced economic activity in developing economy tempers demand for infrastructure
build
-
outs. Oil and nat
ural gas prices remain low, leading to less demand for drilling supplies.
GECC revenues are flat.
VALUATION SCENARIOS
Page
32
PROFITABILITY BEST
-
AND WORST
-
CASE
Because GE
’
s profitability over the past few years has been negatively affected by consumer
finance divestitures as well
as by generally soft economic conditions, it is difficult to disentangle
the baseline profitability of the remaining businesses. However, considering the evidence for
operational leverage and the fact that the consumer finance divestments are complete, we
believe the capacity for the firm to convert revenues to profit will likely fall between the
following levels:
Best case
: Forward five
-
year average OCP Margin of
17%
Worst case
: Forward five
-
year average OCP Margin of
12%
Graphically, these assumptions are
represented in figure
16
.
Figure 17
. Source: Company Statements, IOI Analysis
In comparison,
GE
’
s highest profitability for a five
-
year stretch within the last 10 years was 2004
-
2008, with an average OCP margin of 19%. The lowest average five
-
year OCP m
argin was 14%,
VALUATION SCENARIOS
Page
33
recorded over the last five years. Our best
-
case scenario assumes that profitability will be
slightly lower due to the reduced exposure to consumer finance. Our worst
-
case scenario
assumes that present low profitability is GE
’
s new base
-
line
profit margin for a relatively weak,
though still expansionary economic environment.
INVESTMENT LEVEL
GE
’
s recent divestiture program and its prior acquisition program have clouded the picture
regarding the requisite level of profits needed to be spent t
o generate a better
-
than
-
trend
expansion of profits.
From our perspective, GE
’
s product and service offering is well
-
focused and its business
strategy is well
-
conceived. As such, we assume that
future Net Expansionary Cash Flows as a
percentage of Owners
’
Cash Profits will be the long
-
run historical average of 20%.
Figure 17
. Source: Company Statements, IOI Analysis
VALUATION SCENARIOS
Page
34
Certainly, this projection may be materially wrong in any single year, but over the explicit
forecast period, this seems a reasonable spendin
g level.
FREE CASH FLOW TO OW
NERS
Combining the above three explicit period valuation drivers, we generate an implicit forecast
for FCFO for the firm.
Figure 18
. Source: Company Statements, IOI Analysis
Clearly, now that the divestiture program is windi
ng down, we cannot expect FCFO margins to
return to the divestiture
-
era level.
MEDIUM
-
TERM BEST
-
AND WORST
-
CASE GROWTH
For our medium
-
term forecast, which we call the Investment Stage and which we assume to
be between years six and 10 of our model, we con
sider the likely efficacy of present
investment spending on future cash flow growth.
VALUATION SCENARIOS
Page
35
Best case
:
Medium
-
term (years 6
-
10)
average
profit growth of 7%.
Worst case
:
Medium
-
term (years 6
-
10) average profit growth of 5%.
Given
GE
’
s maturity and the nature of i
ts businesses, a GDP
-
like growth should be available to
the firm at the levels of investment we have modeled. Indeed, considering the level of GE
’
s
spending on R&D and on expansionary projects, a GDP
-
like growth rate
could be
consider
ed
a
worst
-
case outcom
e.
Considering
GE
’
s strong competitive position, its expanding IP portfolio, its strategic positioning,
and the evidence for operational leverage, we consider a best
-
case scenario for medium
-
term growth to be roughly 40% higher than our assumptions for no
minal GDP growth.
LONG
-
TERM GROWTH
All IOI forecasts assume that longer term, the rise in U.S. GDP will be on the order of 5%
(compared to a post
-
War average of 6.4%), so our GE model builds this growth rate into the
forecast for terminal FCFO growth.
Clie
nts wishing to change this assumption can do this using the IOI Valuation Model for GE.
VALUATION SCENARIOS
Page
36
VALUATION SCENARIOS
Figure 19
. Source: Company
Statements, IOI Analysis
Case / Scenario
Value
PSR Implied Low
15
252
-
day Low
24
1% | 12% | 5%
26
*
1% | 12
% | 7%
28
252
-
day High
28
5% | 12% | 5%
30
5% | 12% | 7%
32
1% | 17% | 5%
39
1% | 17% | 7%
42
PSR Implied High
44
*
5% | 17% | 5%
45
5% | 17% | 7%
48
N
OTES TO
T
ABULAR
D
ISPLAY
(
SEE ALSO
A
PPENDIX
)
Valuation Scenarios
1%
|
12%
|
5%
Avg. Revenue Growth =
1%
Avg. OCP =
12%
Avg. Med.
-
Term Growth =
5%
Scenarios marked with an asterisk are IOI most
-
likely worst
-
and best
-
case scenarios. Gray values deemed
econom
ically invalid.
PSR Implied Low
price multiplies IOI
’
s average worst
-
case
revenues for explicit valuation period by the 1
st
decile
cutoff value for historical price
-
to
-
sales ratio.
PSR Implied
High
price multiplies IOI
’
s average best
-
case revenues
during explicit valuation period by the 9
th
decile cutoff
value for historical price
-
to
-
sales ratio.
Curve indicates probability
distribution as estimated by the
option market
VALUATION SCENARIOS
Page
37
VALUATION SCENARIOS
NARRATIVE
Case /
Scenario
Value
Notes
PSR Implied
Low
15
252
-
da
y Low
24
1% | 12% | 5%
26
M
oribund global economy over the next five years, followed
by
no rebound
in the medium term. GE’s profitability has
structurally reset to a low
-
teens level and, without more robust
economic activity, remains at this level in th
e short
-
term.
*
1% | 12% | 7%
28
M
oribund global economy over the next five years, followed
by a rebound in the medium term. GE’s profitability has
structurally reset to a low
-
teens level and, without more robust
economic activity, remains at this level
in the short
-
term.
IOI
CONSIDERS THIS A MOST
-
LIKELY WORST
-
CASE SCENARIO.
252
-
day High
28
5% | 12% | 5%
30
E
conomic activity is robust enough over the next five years to
generate a healthy increase in revenues,
with GDP
-
like
growth continuing
in the me
dium term. GE’s profitability has
structurally reset to a low
-
teens level
.
5% | 12% | 7%
32
Economic activity is robust enough over the next five years to
generate a healthy increase in revenues, with better than
GDP growth in the medium term as a functi
on of bounce
-
back demand. GE’s profitability has structurally reset to a low
-
teens level.
1% | 17% | 5%
39
Moribund global economy over the next five years, followed
by
no rebound
in the medium term. GE’s profitability returns to
near its historical leve
ls as the overhang from divestments
clears.
1% | 17% | 7%
42
Moribund global economy over the next five years, followed
by a rebound in the medium term. GE’s profitability returns to
near its historical levels as the overhang from divestments
clears.
P
SR Implied
High
44
*
5% | 17% | 5%
45
Economic activity is robust enough over the next five years to
generate a healthy increase in revenues, with a continuation
of GDP
-
like growth in the medium term. GE’s profitability
returns to near its historical lev
els as the overhang from
divestments clears. IOI CONSIDERS THIS A MOST
-
LIKELY BEST
-
CASE SCENARO.
5% | 17% | 7%
48
Healthy economy in the short
-
term followed by a robust
rebound in the medium term. GE returns to its historical
profitability. IOI CONSIDERS
THIS SCENARIO UNLIKELY.
VALUATION SCENARIOS
Page
38
A valuation that equally weights what IOI considers the two most likely valuation scenarios
—
$
28 per share and $45 per share
—
generates a most likely valuation of $34 / share.
SCENARIO
FAIR VALUE
ESTIMATE
CHANGE FROM
$
26
Worst
-
Case
$
28
8%
Best
-
Case
$
44
69%
Weighted Average
$
36
43%
INVESTMENT STRATEGY
Page
39
Investment Strategy
INVESTMENT STRUCTURE
DIRECTION
RELATIVE
VALUATION
IMPLIED STRATEGY
Upside
Undervalued
Long stock, Long call option
Downside
Overvalued
Short Put
In this
kind of a case, where the
downside valuation risk is negligible and the potential upside is
large, IOI recommends
a hybrid investment structure that overlays ITM call options on a long
stock position
with cash in reserve
.
This type of hybrid structure utilizing
ITM call options ac
complish
es
several things:
Minimize
s
the
amount of time value expended in the
option leg of the investment
investment (money spent on time value should be considered a realized loss)
Allows for investor to conserve capital versus investing in the underlyin
g stock
(or take a
larger notional stake in the firm using the same capital allocation)
Allows for moderate leverage that increases the potential for dollar returns (as opposed
to percentage returns)
Lowers extreme downside risk compared to a full allocati
on of stock
Graphically,
the ITM option leg of this strategy
can be represented in the following way:
INVESTMENT STRATEGY
Page
40
Figure 20
. Source: Company Statements, IOI Analysis
The above illustration shows a call option expiring in January, 2016, struck at $18 per share
(abou
t 30% in
-
the
-
money)
. The orange shading indicates the intrinsic value of an option that is
in
-
the
-
money (ITM).
The further ITM a call is when it is purchased, the greater the capital outlay on the investment is,
but the less critical the interim market mo
vements. In other words, a sudden shock to the
market that prompts a 20% fall in the market at large
will wipe out all of the intrinsic value of a
20% ITM call option, but only two
-
thirds of the value of a 30% ITM call option.
INVESTMENT S
TRATEGY
Page
41
ALTERNATE
STRUCTURE
A much
higher leverage
structure
, but which has a similar risk profile to the ITM call shown
above is what IOI terms a
“
Diagonal
”
—
here, the proceeds from the sale of
(usually)
a
n at
-
the
-
money (ATM)
put option subsidizes the
purchase of an out
-
of
-
the
-
money (OTM) c
all option.
Figure 21
. Source: Company Statements, IOI Analysis
Because the put is being sold ATM and the call is being bought OTM, depending on the
tenors
and strikes
chosen, this investment can generate a net credit
—
meaning an investor will receive
m
oney for agreeing to make this investment.
For example, at present, an ATM put option expiring in March 2015 is selling for $2.75 on the
listed market In contrast, a long
-
tenor call struck at $32.00 and expiring in January 2017 is
presently asked at $0.65.
Using the former to subsidize the latter, the investor would generate a
cash inflow of $2.10.
INVESTMENT STRATEGY
Page
42
If the put expires worthless (i.e., the entire sale price is realized by the investor), the remaining
call option is essentially an investment with infinite leve
rage (because it has no net cost).
INVESTMENT STRATEGY
Page
43
LEVERAGE
IOI measures leverage in a distinctive way that looks at both the risk and the return side of the
equation. For more information about IOI leverage and the thought process behind it, please
see chapter 8 of
The
Intelligent Option Investor
.
A hybrid position, containing cash (17%), call options (33%), and stock (50%) generates an IOI
leverage factor of
-
1.1 / 1.5. Using the IOI most
-
likely fair value (FV) estimate, IOI Leverage and
returns for levered and unlever
ed strategies are as follows:
Assuming a
5%
allocation of capital to the GE investment, an investor would buy two ITM call
contracts struck at
$
18.00
and
95
shares for every
$
100,000
in portfolio value.
FAIR VALUE ESTIMATE
36
Shares Bought (#)
95
Call
Contracts Bought (#)
2
Mkt Value of Shares
2,497.55
Mkt Value of Options
1,668.00
Cash in Reserve
834.45
Capital at Risk
4,165.55
Graphically, the payoff structure at expiration can be represented in the following way:
IOI Leverage
-1.1 / 1.5
Strategy Return at FV
57%
Unlevered Return at FV
37%
INVESTMENT STRATEGY
Page
44
An unrealized loss on the stoc
k and option positions occur between the average purchase
price and the strike price. A realized loss of option premium (virtually all of which represents
intrinsic value of this ITM option) occurs if the option expires below the strike price of
$
18
.
Downs
ide exposure is partially ameliorated by the cash position, but the cash position serves to
dampen returns on the upside as well.
Net gain / loss for this hybrid allocation compares versus the net gain /
loss of a straight stock
allocation can be represent
ed graphically in the following way:
INVESTMENT STRATEGY
Page
45
The hybrid investor is benefited if the stock rises above the average buy price, is relatively
worse off, if the stock price at expiration is between $9 and $18, and is relatively better off if the
option expires when
the stock trades below
$
9
.
INVESTMENT STRATEGY
Page
46
MARKET RISK
GE has business exposure to economically sensitive businesses
—
aerospace and oil exploration
in particular. Its other segments, are all cyclical ones, with the least cyclical business being its
Healthcare segment.
As such, the stock price tends to be affected by short
-
term market perceptions of various
commodities and economic indicators. Oil price fluctuations tend to affect GE due to its
exposure to oil and gas drilling and transmission equipment.
Threats of t
errorism or terrorist incidents involving airplanes or airports tend to affect GE due to
its exposure to aerospace. Interestingly, its Healthcare segment seems to be perceived by
market participants as being related to Tech, so large drops in the NASDAQ Co
mposite can
also sometimes have an effect on GE
’
s stock price.
Five
-
year daily return betas for GE versus the S&P 500, the NASDAQ Composite, and WTI Crude
spot prices
11
are:
S&P
500
:
1.13
NASDAQ:
0.91
WTI Crude:
0.29
As we can see from figure 19, the low pr
ice implied by multiplying the five
-
year average of our
worst
-
case revenue projection by the cutoff for the lowest decile historical Price
-
to
-
Sales Ratio
implies a price of $15.50 / share. If we increase the Price
-
to
-
Sales Ratio statistic to the cutoff for
11
We use the formula for beta of Covariance (
a,b
)/Variance (
b
) where
a
represents the stock
price series and
b
represents the price series for the index or commodity.
INVESTMENT STRATEGY
Page
47
the lowest quartile, and multiply that number by the five
-
year average of our worst
-
case
revenue projection, a low price of $19.50 is implied.
NO
TES
Page
48
Notes
No notes for General Electric report.
APPENDIXES
Page
49
Appendixes
APPENDIX 1: READING
IOI CHARTS
AND TABLES
Valuation v
s. Option Market
G
raph
This is the quintessential IOI graph showing the following elements:
1)
Historical price of the underlying stock over the past year of trading.
2)
Conical section
12
indicating the option market
’
s expectations for the future price of
the
stock (termed the
“
BSM Cone
”
in
The Intelligent Option Investor
).
12
In this diagram, you
may be able to make out
two conical sections. The outer cone, with the
dotted line, represents the
“
ask vol
”
and the solid line the
“
bi
d vol.
”
The fact that the dotted
line is outside of the solid one indicates that the ask price is higher than the bid price, and
APPENDIXES
Page
50
3)
Best, worst, and most likely case valuations based on IOI
’
s fundamental analysis of
the company.
4)
Shaded region showing the area of exposure for the option strategy. Green shading
signifies
gaining exposure through purchase of a contract; red shading signifies
accepting exposure through the sale of a contract; gray shading indicates a
cancellation of exposure. A two
-
toned, orange
-
and green exposure, as shown
above, indicates the purchase of
an ITM option.
5)
Break
-
even line. For bullish strategies, we will use the term
“
Effective Buy Price (EBP)
”
and for bearish ones,
“
Effective Sell Price (ESP)
”.
In this case, the stock price is $28.94
and the seller receives $2.55 in premium, so the EBP is ($2
8.94
−
$
2.55
=)
$
26.39
.
The
theory behind
the
BSM cone and the representation of options
’
ranges of exposure
is
explained in Part I of
The Intelligent Option Investor
, chapters 1
-
2.
Technical details regarding
how BSM cones may be created using market data
are explained in detail in chapter 7.
An investor has an edge when the market price of a stock is significantly different than its
intrinsic value range or when the range foreseen by the option market is much wider or
narrower than that of its intrinsic v
alue range. In the above example, the option market
’
s range
of outcomes is much wider than what we believe the uncertainty of the firm is on a
fundamental basis.
means that the range of possible stock price outcomes as seen by sellers is wider than that
seen by buyers.
APPENDIXES
Page
51
Valuation vs. Stock Market Graph
This graph shows the relationships between four valuati
on / market elements:
1)
IOI valuation scenarios (dark blue and gray columns)
2)
High
-
and low price range for the stock over the last year (red bars)
3)
Stock price range implied by overlaying historical price
-
to
-
sales ratios (PSR) on IOI
’
s
best and worst case rev
enue scenarios.
4)
Option market
’
s probability distribution (curved line)
The table shows the numerical values of the IOI valuation scenarios, the high and low stock
prices, and the stock prices implied by the PSR. All scenarios IOI considers as having a mate
rial
chance of occurring are shaded in dark blue; all scenarios IOI considers as not having a
material chance of occurring are shaded in gray and the height of the bar is relatively low. The
most likely scenario or scenarios (associated with values of $28
and $44 here) are identified by
being the tallest blue bars on the graph.
APPENDIXES
Page
52
The height of the bars is not meant to show a proportional difference in probability of
occurrence. Gray bars will be shortest; material valuation will be tall
er
; IOI
’
s most likely
valuation scenarios will be
tallest
.
The tallest columns correspond to the best
-
and worst
-
case
valuations in the Valuation vs Option Market (BSM Cone) graph.
The curve shows the price range considered most likely by the option market. For a lognormal
curv
e, the point on the curve representing the
“
expected
”
value lies a bit to the right of the
peak of the curve. As such, by looking at the purple curve, you can see the range of stock
prices that the option market considered most likely when these data were
drawn. This curve
represents the BSM Cone in profile view.
Valuation vs. Market Table
Case / Scenario
Value
PSR Implied Low
15
252
-
day Low
24
1% | 12% | 5%
26
*
1% | 12% | 7%
28
252
-
day High
28
5% | 12% | 5%
30
5% | 12% | 7%
32
1% | 17% | 5
%
39
1% | 17% | 7%
42
PSR Implied High
44
*
5% | 17% | 5%
45
5% | 17% | 7%
48
IOI valuation scenarios are identified according to the following convention:
Near
-
term Revenue Growth | Near
-
term Profitability | Medium
-
term FCF growth
Taking this int
o consideration, we can translate the entry listed as
“
5% | 12% | 5
%
”
as
identifying the scenario assuming
5
%
year
-
over
-
year revenue growth and
12
%
profitability
(as
measured by OCP)
for the sta
ge one valuation period and an 5
%
growth in free cash flows
to
owners
in the stage
two
valuation period.
GLOSSARY
Owners
’
Cash Profits
This is a measure of profitability similar to Buffett
’
s Shareholder Earnings.
APPENDIXES
Page
53
Given the emphasis we have placed on the importance of cash and the flow of cash, it makes
sense that we
will find most of the information essential to valuing a company by analyzing the
Statement of Cash Flows (SCF).
In fact, for our calculations of OCP, we need not look much further than the very first section of
the SCF
—
the section entitled Cash Flow from
Operations (CFO). The precise definition of Owners
’
Cash Profit is:
APPENDIXES
Page
54
OCP = CFO
–
Maintenance Capex
Maintenance Capex = [(
1
+inflation rate assumption) × Depreciation Expense]
Even though these are pretty simple equations, there are a few things to be said
about each of
the terms that make up
“
Maintenance Capex
”.
However, before delving into that, please realize
that whenever we are calculating ranges, we are dealing less with hard numbers and more with
estimates and educated guesses. It is vital not to get
hung up on the exact numerical value
being calculated and to conceive of the calculations as an estimate and a starting place to
understand true profitability.
There are two facts to economic life that the OCP calculation attempt to quantify:
1.
Equipment, b
uildings, and other physical assets essential for generating revenues break
or wear out.
2.
Generally, prices for things increase over time.
The OCP equation uses the accounting line item
“
Depreciation
”
to represent the first fact.
Depreciation is meant to f
ormalize the assumption we made about our taxi driver
’
s business
—
that he would need to set some money aside each year to buy a new car when the first one
had come to the end of its economic life.
Depreciation expense is a fiction codified by accounting c
onvention. I will not go into all of the
different ways depreciation might be calculated
—
I can think of three right offhand and there
are probably more
—
since those details would only add confusion. You will notice that the OCP
equation takes that accountin
g fiction and multiplies it by a fiction of economics
—
the inflation
rate (which I usually simply take as the rate for Consumer Price Inflation published by the U.S.
government). I have read fascinating articles about how the present method for calculating
inflation probably ignores things that it shouldn
’
t and why these omissions have taken place over
time. I know that inflation is a fiction and it is not representative of the actual rise in cost that the
company will need to pay to repair its machinery or
spruce up its offices, but still I add inflation
to keep in mind that prices usually increase over time.
The main point is that depreciation is about the best estimate we can get for the amount of
capital expenses needed to maintain the business as a going
concern. Keeping in mind that
all of what we are dealing with when analyzing companies are estimates and that no one will
ever know exactly how much money is needed for maintenance capex at a given company
ahead of time, the estimate we are using seems pl
ausible and directionally right. That
’
s good
enough.
APPENDIXES
Page
55
Expansionary Cash Flow
The proportion of excess profits a company invests in order to enjoy greater than trend growth
in the future.
Because the purpose of these investments is to expand either the rev
enues or profits of at a faster
rate than the economy in which it operates, we call these investments
“
Expansionary Cash
Flows.
”
We start with OCP and define Expansionary Cash Flows like this:
Deduct
Expenditures for Property Plant & Equipment over and abo
ve
maintenance capex as defined in OCP
(“
Growth Capex
”)
Deduct
Cash spent on acquisitions
Deduct
(Add
Back)
Cash paid to (received from) JV partners (loans or investments)
Deduct
Cash spent anti
-
dilutionary stock repurchases
Add Back
Cash received from
sale of assets / divisions
Equals
Expansionary Cash Flows
Fiscal Year Ending
2009
2010
2011
2012
2013
E
stimated Growth Capex
(258)
77
(71)
(147)
(88)
(Acquisitions)
(1,159
)
(5,606
)
(1,847
)
(4,702
)
(3,305
)
(Investments in) Payments from
JVs, etc.
-
-
-
-
-
(Antidilutionary Share Buybacks)
(1,464
)
(1,422
)
(2,311
)
(1,274
)
(2,780
)
Asset Sales & Disposals
-
-
105
-
-
Net Expansionary Cash In
-
(Out
-
)
Flows
(2,881
)
(6,951
)
(4,124
)
(6,123
)
(6,172
)
Estimated Growth Capex
In our calculation of OCP, we already made an estimate of the amount of money that is needed
to maintain the company as a going concern
—
maint
enance capex. Keeping that number in
mind, we can also look in the
“
Cash Flow from Investing
”
section of the Statement of Cash Flows
APPENDIXES
Page
56
and find a line item related to spending on
“
Property Plant & Equipment (PP&E)
”
This is what
analysts usually look for as a
measure of capital expenditures.
The first line in our calculation of Expansionary Cash Flows is simply the amount of money spent
on PP&E less the amount of money we have already estimated as necessary for maintenance
capex. Usually, PP&E will be greater
than inflation
-
adjusted Depreciation, but in the case of
Oracle, we can see that this is not always the case
—
note the cash inflow of $77 in 2010
associated with expansionary capex. This simply means that the company has temporarily
“
underinvested
”
in maint
enance capex. For a company like Oracle, which mainly derives
revenues from its intellectual property rather than from manufacturing and selling physical
goods, this is not strange. For a manufacturing company, though, if one sees that one
’
s estimates
for
maintenance capex are consistently higher than the amount the company is actually
spending on PP&E, one needs to do some further investigation to figure out why. The company
might be outsourcing more of its manufacturing
—
which is not necessarily a bad thin
g
—
but the
company might also simply be underspending on maintaining its productive assets
—
which is
always a bad thing.
Acquisitions
In a 1992 interview with the Harvard Business Review, Phil Knight, co
-
founder of the sporting goods
company Nike, spoke abou
t the decision that company managers face regarding buying or
building new product lines. In this quote, Knight is talking about his decision to acquire casual
shoe brand Cole
-
Haan.
“
We bought [Cole
-
Haan] knowing its potential, and we
’
ve simply turned up t
he
marketing volume. We could have created a brand and got it up to $60 million
in sales, which is where Cole
-
Haan was when we bought it, but it would have
taken millions of dollars and a minimum of five years. W
’
re further ahead this way.
In the four year
s we
’
ve owned Cole
-
Haan, it
’
s repaid the purchase price and is
now at
$
150
million in sales.
”
From this quote, it is obvious that money spent to acquire a business
—
which subsequently
becomes a division of the acquirer
—
should be considered as substantively
the same as money
spent to buy equipment and buildings in order to build up a new division. It is amazing to me that
so many analysts and strategists ignore spending on acquisitions as a deduction from free cash
flows. Certainly, whether one spends money t
o buy a business or to build one, that money has
been invested and thus cannot be distributed to equity owners.
This reasoning suggests we must include cash spent on acquisitions into the calculation of
expansionary cash flows.
Antidilutionary Share Buybac
ks
APPENDIXES
Page
57
Cash outflows associated with anti
-
dilutionary stock repurchases arise from two situations:
1.
Management issues shares to acquire another company
2.
Management issues shares to employees and executives
In most cases, company managers issue shares as a form o
f currency to pay for some strategic
project (an acquisition in the first case, encouraging development of greater intellectual
property assets in the second). However, company managers are evaluated
—
both by boards
and the equity market
—
by trends in earnin
gs per share (EPS). Because of this, issuing shares can
become dangerous from a career security perspective to CEOs and CFOs
—
issue too much
equity too often, and one
’
s EPS will be negatively affected.
Enter the corporate hobby of stock repurchases.
Academi
cs have encouraged a belief amongst investing professionals and the public at large
that stock buyback programs
“
create value
”
for shareholders. Of course, the company
’
s
purchase of shares does make one
’
s own stake more valuable, so to the extent that buyb
ack
programs do increase the concentration of one
’
s position, they are helpful to long
-
term
shareholders. The problem is that some proportion of these programs do not increase the
concentration of ownership interests, but merely limit the dilution of them.
Management teams proudly announce their enormous buyback plans knowing that these
massive purchases will swamp the millions of dollars here and there spent to 1) obfuscate the
mediocre results of a prior acquisition and / or 2) hide the true extent of st
ock issuance as a form
of employee compensation.
Stock buybacks use owners
’
cash in order to boost EPS. It is for this reason that, in most cases, we
consider all the stock issued by a company for acquisitions or compensation schemes in a given
year as hav
ing to be bought back at the average price of shares that year. For instance, the
$
1,464
spent by Oracle in
2009
is a result of its purchasing
81
shares at an average price of just
over
$
18
per share.
Fiscal Year Ending
2009
2010
2011
2012
2013
(Antidilut
ionary
Share
Buybacks)
(1,464)
(1,422)
(2,311)
(1,274)
(2,780)
Of course, this is only an estimate of the true value of the cash expended on antidilutionary stock
buybacks, but even though it is a fiction, it is a useful one and likely directionally right
in terms of
the absolute amount spent.
Cash Received From (Paid To) JVs, Internal Software Development, etc.
APPENDIXES
Page
58
Investing in JVs does not represent a
huge part of
the company in this example
’
s
business
strategy, but it can be for some firms. For instance, NA
ND Flash memory producer SanDisk (SNDK)
forms JVs with Japanese chipmaker Toshiba and both firms contribute capital to these JVs. The
JVs purpose is to build (enormously expensive) chip fabrication facilities, produce chips, and sell
them to the owners of
the JVs (i.e., SanDisk and Toshiba) at the cost of production. The JVs pay
interest to the parent companies, and if there are any excess profits, those profits are divided
proportionally between the parents as dividends.
Clearly, this example of a loan mad
e to a JV is exactly the same as money spent to fund a
capital project to build a fabrication plant. The cost of funding such a plant is so high that the
two partners can spread risk and reduce their annual capex bill.
Clearly these expenditures should be
treated as expansionary outflows and any interest or
dividends received should be netted out against it.
Cash Inflow from Asset Sales
Clearly, any cash that flows in from a company
’
s sale of equipment, a division, or a property
should be treated
as a sourc
e of cash that can be used to buy new assets
. Oracle, being an
asset
-
lite company, does not have much in the way of asset sales or disposal of divisions, but you
can see that in 2011, it sold something worth $105 that we have counted as a net inflow agains
t
growth capex that year.
Free Cash Flow to Owners (FCFO) and Assessing Investing Efficacy
Once we have estimated OCP and understand how much of it the management is spending
on expansionary projects, we finally come to the number by which we value the fi
rm
—
Free Cash
Flow to Owners. In equation form:
FCFO = OCP
–
Expansionary Cash Flows
IOI CONT
ACT INFORMATION
Page
59
IOI
Contact Information
For any questions about methodology, content, or your subscription, please contact Erik
Kobayashi
-
Solomon.
Tel
732
261
5022
Email
erik@intelligent
optioninvestor.com
Intelligent Option Investor, LLC
1010 North Drury Lane
Arlington Heights, IL
60004
www.IntelligentOptionInvestor.com
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