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Earnings Power

GE's Growth Looks Short-Circuited

By Hewitt Heiserman

Special to

07/17/2003 10:01 AM EDT

With General Electric (GE:NYSE - news - commentary) down 50% from its all-time high and talk of an economic recovery, is now the right time to buy a big slug of this industrial/financial concern?

If you're a long-term, cautiously greedy investor, the answer is "no." Here's why: First, GE's earnings power is mixed; second, its yield on incremental investment is poor; and third, there's too much debt as a percentage of tangible book value.

Earnings Power Is Mixed

As we see in the first chart, GE was profitable on a GAAP/accrual basis every year for the five years ended Dec. 31, 2002. The firm also was profitable on an enterprising basis; i.e., its return on capital was greater than the cost of capital. Of concern, however, are the defensive losses; i.e., negative free cash flow.

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One reason GE has defensive losses is its huge investment in fixed capital. In 2002, for example, management invested $38 billion in buildings, real estate, machinery and acquisitions. This results in a use of cash not captured dollar-for-dollar in the year incurred in the other two income statements.

GE also is making a huge investment in working capital -- $35 billion last year. That means current assets like receivables and inventory are growing faster than current liabilities like payables and accrued expenses. This, too, is an indirect charge in the accrual and enterprising ledgers.

The combination of defensive losses and enterprising profits means GE is situated in the Earnings Power Chart's lower-right box. Ideally, the Fairfield, Conn.-based company would be in the upper-right box and continuing to move in an upper-right direction -- what I call an Earnings Power Staircase company. When a company forges a Staircase, that's the hallmark of a great growth stock.

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(Many companies actually have two types of investment in fixed and working capital: maintenance and discretionary. As a result, some analysts add back to defensive profits (losses) the discretionary portion, reasoning that, in a pinch, management can cut back on these "growth-producing initiatives" and instead use the extra funds to service debt, repay loan principal, etc. If you use one income statement, this adjustment makes sense. However, in a dual income statement approach, I prefer to be extra cautious and expense all investment in the defensive model. For one thing, outlays for capital spending and working capital increases are uses of cash. Also, you never know which investments will pay off and which will be duds.)

Low Yield on Incremental Capital

Another concern is the low yield on incremental capital, what I call the return on greenest dollar, or RGD. As shown below, if you divide the change in GE's net operating profit after tax, or NOPAT, for the three years ended 2002 by the change in capital, you get a 5% yield. That's not much bang for your buck. For the three-year periods ended 2001 and 2000, the RGD was 5% and 7%, respectively. Despite its size, I'd like to see GE produce a double-digit RGD.

Why the low incremental returns? My bet is that management is overinvesting in its myriad businesses in an effort to keep growing revenue and net income.

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Too Much Debt

A third issue is GE's debt as a percentage of tangible book value. Tangible book value is just corporate net worth minus goodwill and intangibles. If a company has a high debt-to-tangible book, or DTB, ratio, it has fewer assets to sell if cash flow dries up and the company gets in a pinch.

Mind you, GE is not a credit risk. Cash and investment securities are 46% of debt, where it's been since the mid-1990s. Also, the conglomerate's ratio of EBITDA-to-interest is about 3 times -- a good number. And then there's GE's triple-A rating from Standard & Poor's. (In a report issued last week, credit ratings agency Egan-Jones said GE looks more like a AA credit rating, citing, among other things, its need to move $50 billion in assets and liabilities onto the balance sheet.)

Still, as shown below, GE has the highest DTB ratio of any of the world's most valuable companies as measured by market value, at 1,679%. In second place is Citigroup (C:NYSE - news - commentary) , at 654%. Seven companies on this list have DTB ratios under 100%.

|World's Most Valuable Companies |

|Symbol |Company |Period Ending |Market Value |Debt % Tangible Book |

| | | |($Bils.) | |

|GE |General Electric |3/03 |$281 |1679% |

|C |Citigroup |3/03 |238 |654 |

|AIG |American |3/03 |149 |132 |

| |International Group | | | |

|WMT |Wal-Mart |4/03 |248 |84 |

|PFE |Pfizer |3/03 |248 |54 |

|BP |BP plc (ADR) |3/03 |151 |33 |

|JNJ |Johnson & Johnson |3/03 |154 |27 |

|XOM |Exxon Mobil |3/03 |238 |14 |

|INTC |Intel |3/03 |152 |3 |

|MSFT |Microsoft |3/03 |293 |0 |

|Source: Multex; |

General Electric also has the highest DTB ratio among credit service businesses (American Express (AXP:NYSE - news - commentary) , with a market cap of $57 billion, is a distant second at 250%), money-center banks (J.P. Morgan (JPM:NYSE - news - commentary) has a DTB of 743%) and insurance companies (ING's (ING:NYSE - news - commentary) ratio is 472%).

The most intriguing comparison, though, may be with Berkshire Hathaway (BRKA:NYSE - news - commentary) . Like GE, Berkshire has many operating companies, as well as a large financial services business (reinsurance). But Berkshire's DTB ratio is a scant 19%. That Warren Buffett, he's no fool when it comes to managing balance sheets -- that's why he's worth $30 billion.

I'd like GE better if it would cut back on investment and pay down its debt.

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Hewitt Heiserman has been a financial analyst for 15 years and has worked for Fidelity Investments, Simplex Time Recorder, American Holdco and Breakaway Solutions. He is now writing a book on the Earnings Power Box, an analytical model he created to gauge the quality of a firm's profits. (The Earnings Power Box is a trademark of Hewitt Heiserman.) At the time of publication, Heiserman was long GE via mutual fund holdings, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Heiserman appreciates your feedback and invites you to send it to hewitt.heiserman@.

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