- General Electric Company Stock Sold Off After Announcing A Q2 Beat. Oil & Gas and Transportation were the main culprits.
- However, bullish crude oil fundamentals and ongoing cost cutting measures will ensure the stock will remain elevated.
- If GE can continue to increase margins in a difficult macroeconomic climate, downside risk would be negated in my opinion.
General Electric Company (NYSE:GE) dropped to almost $36 a share last Friday as the market didn't take very well to its second quarter fiscal results. Furthermore, the 2% sell-off happened as the S&P 500 (INDX:SPAL) tagged on almost 10 handles, so in one sense, shareholders can consider themselves quite fortunate. Power and renewable sales powered the company's second quarter earnings per share of $0.51 but it wasn't enough to stop the stock from falling. Oil & Gas and Transportation divisions dragged the company's industrial segment down by almost 1%.
This means GE has left itself with plenty to do throughout the second half of this year to achieve its 2 to 4% organic sales growth target for fiscal 2016. It will be banking on its strong backlog (Aviation has a $150+ billion backlog and Power is expected to ship 110 turbines by year end) to hit its organic sales number. However, a lot will rest on the global macroeconomic environment. Can it hold up? It doesn't look like it can at present with GE's competitor Honeywell International (NYSE:HON) cutting its full-year guidance a few days ago. This is what investors are afraid of. With a forward earnings multiple of 21.4, the stock looks on the pricey side. However, its fiscal second quarter earnings provided me with some pockets of strength which have the potential to keep the stock elevated for some time yet.
Crude Oil Is Going Higher Which Will Boost GE's Oil & Gas Division
General Electric will continue with its cost-cutting efforts in an effort to stem the tide from its oil and gas losses. In fact, $800 million of savings have been targeted by the company in this division. Orders came in 34% lower than the quarter of 12 months prior and revenues whereas sales tanked by 22% and profits by 48%. All the Industrials believe that with crude trading around the $44 level, demand will continue to be poor for the remainder of the year. Here is where I actually see some upside for this division. Why? Well as crude oil has corrected from the $51-$52 level, energy stocks have kept on powering higher. This is why I believe a bottom will come soon in the oil market. Crude oil above $60 a barrel becomes a different proposition indeed for GE - something many analysts are not spotting.
The Above Average Dividend Yield Will Attract Income Investors
Secondly, GE's dividend yield of 2.8% should grow in the next few years despite the dividend remaining static for the last 6 quarters. General Electric lost its dividend aristocrat status in 2009 when the sheer force of the financial meltdown was too much to handle. However, with the company divesting of its financial assets and with its debt to equity ratio at its lowest level over the last decade (1.48), there is ample reason that the company will continue to raise its dividend once this sluggish growth phase is behind us.
The company's pay-out ratio is currently 143% but this metric shouldn't deter dividend investors from investing. Why? Well, the company expects to return $18 billion to shareholders through buybacks in 2016 and $8 billion through dividends. Therefore, dividend investors should watch the rate at which buybacks are occurring. Consistent dividend growth rates are much easier to implement when the share count is less. However, with $31 billion of free cash flow expected this year and margins steadily improving, General Electric yield actually looks stable as the company slowly returns to its roots of being an Industrial company
The Shift Into Digital, Alstom Improvements And Focus On The Aftermarket Will All Lead To Higher Margins
Furthermore, although organic revenue growth was poor in the second quarter, industrial operating margins were flat (at 14.2% excluding Alstom) which illustrated that the company is making progress here. How GE works is that the more products it ships, the better its cost basis usually is. We saw a gross margin expansion of 110 basis points last quarter and I think this metric will only improve as the company slowly reduces its cost basis across its portfolio as more and more items get shipped. The product mix of lower margin items from Alstom has hit GE's profit margins over the first part of the year. However, a greater number of much higher priced products (turbines and engines) are due to be shipped over the second part of the year so margins should rise even more. Therefore, when you combine the shift into a leading "Digital Industrial" company (which have high margins - see chart) and the huge R&D budget, gross margin levels will undoubtedly go higher. This will do wonders for free cash flow and will support shareholder returns going forward.
To sum up, GE may have reported a mixed second quarter but guidance for the second half of the year is much stronger. A strong backlog of products to be shipped, higher margins and higher oil prices should all be bullish for the company going into the second half of the year. If the stock dips into the 20's, it would look like an attractive long in my opinion.