GE: If It Quacks Like a Bank...


By Sam Jaffe When most people think of General Electric (GE), they think of an industrial conglomerate that makes airplane engines and power-generation equipment. But it might surprise you to know that the single-largest segment of GE's operations now is its financial-services arm, GE Capital Corp. And that segment is growing rapidly.

In fact, GECC is starting to stick out as if it were the awkward 16-year-old who had just shot up to six feet in the midst of his smaller, slower-growing siblings. With the recent acquisition of Heller Financial and its $1 billion in 2000 revenue, the unit now accounts for slightly more than 51% of GE's total annual revenue.

So should investors be thinking of GE as essentially a bank stock? Yes and no, though it certainly is an interesting prism through which to view this icon of Corporate America.

PERFECT STRATEGY. Let's assume that GE is a bank stock. If so, at $42 a share, it's overpriced even though it has dropped by a third over the past year. Bank stocks -- even the best-run institutions -- carry much lower multiples than successful manufacturing stocks. Take a look at the average price-to-earnings ratio of the Standard & Poor's 500 industrial conglomerate industry group vs. the S&P money-center banks group. Conglomerates have an average trailing p-e of 28.9. GE's is slightly higher, at 29.9, while the bank stocks' average p-e is only 19.6.

GE Capital's business model remains essentially the same as always: Buy small and midsize companies that have good businesses with fat to cut, and then whip them into shape as top performers. Jack Welch's famous strategy of being No. 1 or No. 2 or get out of that line of business has worked perfectly for GECC. Case in point: its exit from car leasing this past year, which will cause a hit to revenue growth but will add significantly to future earnings growth.

This lucrative division exemplifies the GE way: grow and adapt. "If things keep the way they are, then GE would just slowly, gradually transform into a bank," says Prudential Securities analyst Nicholas Heymann. "But things never stay as they are at GE." Heymann expects new CEO Jeffrey Immelt, set to take the reins in October when Welch officially steps down, to make some major acquisitions on the industrial side as a way of adding his mark. That will take some of the focus off GE Capital.

NOT LIKE CITIGROUP. Don't forget: GE is still regrouping from a failed $40 billion merger attempt with Honeywell (HON) after European Union trustbusters scotched the deal. That merger would have changed the company in many fundamental ways, including diminishing GECC's prominence overnight. "Don't compare us to Citigroup, because Citigroup doesn't make turbines," insists GE spokesman David Frail.

Most analysts who follow GE agree. "You can't just look at revenue when you're talking about financial services," says Steve O'Neil, an analyst with Hilliard Lyons who has a buy rating on the stock. "On an earnings basis, GE Capital is much smaller in proportion to the rest of the company."

True, but not by much. According to GE's 2000 annual report, GE Capital still accounted for about 40% of operating earnings. And that share is likely to increase this year, because earnings growth at GECC is outpacing that of the rest of the company even as GE acquires other financial-services firms and growth in nonfinancial units slows.

"BETTER PROPOSITION." Heymann's guess is that GE will still go after pieces of Honeywell slated to be sold in 2002. Honeywell is in the midst of a massive reorganization and is expected to divest numerous assets. "GE will be first in line," says Heymann. "They wanted Honeywell primarily for the avionics division, and Honeywell will probably sell that off first. It's an even better proposition than the original merger plan." Heymann also thinks GE might be interested in Honeywell's home-security division.

If GE can pull off such large acquisitions, it could add tens of billions of dollars of revenue to its industrial side. Already, some of its industrial divisions are enjoying extraordinary growth despite the economic slowdown.

GE Power Systems, which makes turbines for the electric utility industry is expecting to grow by 35% this year, primarily because of the massive, sudden build-out of the electrical grid. But that build-out won't be so massive in a couple of years. When it slows down, Power Systems' share of the GE revenue and profit pie, which now stand at 11% and 15%, respectively, will drop considerably.

EXHAUSTIVE MODELS. No wonder it has become so tricky for investors to figure the best way to calculate GE's value. One method is to break out each subsidiary and compare its p-e and price-to-sales ratios to those of its direct competitors. Many analysts have created exhaustive models based on this approach, including Jeffrey Germanotta of William Blair & Co., who has a buy rating on the stock.

According to his calculations, GE's parts are still worth more than a weighted average value of its rivals in each competing sector. Germanotta says a hefty premium should be expected for a company that had an overall return on equity of 27.6, compared to a weighted average ROE of 15.4 for its competitors. "In the end, this is a very well managed company, and it deserves a premium for that," he says.

"You can't call GE a financial services company in the same sense that you can't call it an industrial manufacturer," says GE spokesman Frail. "It's a combination of multiple businesses, all of which have different cycles and different valuation metrics."

Fair enough. But until GE makes its next strategic move, investors shouldn't lose sight of the fact that GE Capital produces the majority of GE's revenues and more profit than any other division, and both those numbers should continue growing quickly in the future. And whether it's price-to-earnings, price-to-sales, price-to-cash-flow, or price-to-book, banks are generally valued at between a third to a half that of industrial conglomerates. In the short term, financial services are driving this locomotive. Jaffe writes about the markets for BusinessWeek Online in our daily Street Wise column

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