One Old, One New, Both Buys
08/30/2011 8:30 am EST
These two companies have entered the consciousness of not only most Americans, but most people in the world, and their stocks are both looking attractive here, writes Paul Larson of Morningstar StockInvestor.
General Electric (GE) has made a large transformation for the better in recent years by selling off its media business and reducing leverage. Though not a table-pounding bargain, the stock does look moderately cheap today.
General Electric positions itself to be a leader in all markets in which it competes. After shedding underperforming businesses during the past few years, the firm has energy infrastructure square in its sights.
We believe GE will emerge as a leader in the power infrastructure market, which will be the backbone for the firm’s growth.
With its legendary knack for squeaking out operating efficiencies, the firm is able to generate healthy returns on invested capital in many of its markets. By focusing its efforts on the most value-added components for customers, GE is able to remain relevant with customers and focus its research and development efforts on projects that customers will be willing to pay the most for.
The portfolio of businesses continues to be correlated with industrialization and the needs of growing economies. GE has changed its focus as the world has shifted; it now has a heavy focus on clean-energy products, such as wind and gas turbines.
The strength of GE’s competitive advantage is most notable in wind turbines, where the company was able to unseat longtime incumbent Vestas with its superior manufacturing execution and better customer satisfaction.
Our upside and downside scenarios aren’t going to vary greatly from the base case on the industrial side, given GE’s long-cycle businesses and high proportion of service revenue inherent in the model. However, we can envision a scenario today where the company may be worth as much as $35 per share.
In this scenario, revenue would have to grow by low double digits for the next four years and margins would have to expand to the high teens. Though unlikely, this is possible as GE has significantly upgraded its portfolio over the past couple of years—but hasn’t yet enjoyed the volume levels of prior years.
Operating margins in the industrial business did reach this level in the early 2000s, but this was amid a power bubble that probably powered margins past what we would assume is attainable under current conditions.
In addition, a strongly expanding economy is likely to power GECS’ earnings past the roughly $7 billion we are assuming is the normalized earning power of the unit in our base case several years hence.
On the other hand, if the economy limps along for several years and GE enjoys only GDP-like growth or less, the stock is probably worth less than $20 per share. In this scenario, we estimate the industrial business would only attain margin levels similar to today and GE Capital may again be consumed by net losses, increasing reserve levels, and possibly more capital contributions from the parent.
Given the amount of restructuring done at the company level and our relatively upbeat outlook for industrial activity throughout the world, we think the downside scenario is less likely than the other two.
NEXT: King of the Jungle|pagebreak|
King of the Jungle
After being on or near the “consider sell” portion of the wide-moat watchlist for many moons, we recently updated our take on Amazon (AMZN) and upped our fair value estimate.
A shakeout among traditional brick-and-mortar retailers is underway, particularly in commodified categories. With minimal customer switching costs and intense competition, we’ve already seen Circuit City, Linens ‘N Things, and Borders Group meet their demise the past few years, while names like Best Buy (BBY), Barnes & Noble (BKS), Office Depot (ODP), and OfficeMax (OMX) struggle to reverse negative same-store sales trends.
Mass merchants like Walmart (WMT) and Costco (COST) have certainly played a role in this trend, as has the rapid growth of key vendors like Apple (AAPL). However, we believe the most disruptive force in retail in recent years has been Amazon.com.
Amazon’s low-cost operations, network effect, and laser focus on customer service provide the company with sustainable competitive advantages that traditional retailers cannot match, which should yield additional market share in coming years. Coupled with one of the most capital-efficient models in e-commerce, Amazon generates returns on invested capital exceeding 50%.
Amazon’s primary advantage is its low costs. Maintaining its network is much cheaper than maintaining a large physical retail presence, allowing Amazon to price below its brick-and-mortar peers while still generating excess economic returns.
Additionally, tax laws mandate that online retailers collect sales tax in states where they have a physical presence, with the tax responsibility falling to the end consumers themselves. As a result, Amazon presently collects sales tax in five states where it maintains a physical presence, providing additional cost advantages.
Our fair value estimate is $235 per share. Our updated fair value estimate implies fiscal 2012 price/adjusted earnings of 42 times, enterprise value/adjusted EBITDA of 22 times, and a free cash flow yield of 4%.
Though the relative valuation multiples appear lofty versus consumer industry averages, our model incorporates three-year earnings per share and free cash flow CAGRs of 38% and 22%, respectively, thus warranting a premium valuation multiple.
Amazon’s strong competitive positioning and contribution from recent acquisitions should lead to additional share gains this year, putting full-year revenue growth close to 40%. Our model assumes average annual revenue growth of approximately 28% during the next five years, resulting from market share gains from traditional retailers, the ongoing secular shift to online retail, and international expansion (particularly China).
Additionally, we expect the addition of new product categories to drive average annual revenue growth of around 36% during the next five years in the electronics and other general merchandise category (nonmedia products). We anticipate slower (yet relatively stable) growth in sales of media products (12% average annual revenue growth) due to the shift to digital formats and Amazon’s already sizable market share.
We project that gross margins will remain flat around 23% over the duration of our ten-year explicit forecast period. We expect returns on invested capital (excluding goodwill) to exceed 50%.