Buffett Sees the Light in GE

Some stocks are labeled bellwethers for good reason. General Electric, the huge conglomerate whose reach extends into industry, health care, media and financial services, has long been considered a barometer for the economy. These days, for better or worse, the company is emblematic of the problems roiling the financial markets overall and financial firms in particular.

GE shares have taken a wallop on not-very-surprising news of weakness at the company's financial-services arm, which lends money to consumers via private-label credit cards, such as Home Depot's, and to industrial buyers of its airplane engines, turbines, windmills and train locomotives. GE Capital Services provides almost half the profits for this strapping conglomerate -- enough to earn the parent company a place on the Securities and Exchange Commission's no-short-selling list of financial firms.

On October 1, the pounding got to be too much for bargain-hunter-in-chief Warren Buffett. The Berkshire Hathaway chief executive struck a deal with GE to purchase $3 billion in preferred stock, which comes with the option to buy $3 billion more in common shares at $22.25 each, exercisable for five years.

Subscribe to Kiplinger’s Personal Finance

Be a smarter, better informed investor.

Save up to 74%

Sign up for Kiplinger’s Free E-Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

Sign up

GE also announced that it would offer at least $12 billion in stock to the public, expected to be priced by underwriters on October 2. "GE is the symbol of American business to the world," said Buffett. "I am confident that GE will continue to be successful in the years to come."

GE shares (symbol GE), trading as low as $23 prior to the announcement, spiked to nearly $26 a share on the news but closed for the day at $24.50.

Investors who take GE up on its offer will be buying into a company with a stellar long-term reputation and daunting short-term challenges. On September 25, as Wall Street ran amok amid bailout rumors and Washington Mutual was seized by the federal government, GE announced that it was cutting its profit forecast for the third quarter and for the year because of "difficult conditions in the financial-services markets that are not likely to improve in the near future."

Instead of earning $2.20 to $2.30 a share this year, a slight increase over 2007 levels, GE said $1.96 to $2.10 a share was more likely -- which would result in an earnings decline of as much as 11%. Wall Street analysts hurried to slash their own estimates, their price targets for the stock and, in some cases, their recommendations. Standard & Poor's, for instance, downgraded the stock from "buy" to "hold," and at least five other analysts have downgraded the stock this year.

On average, analysts now expect the company to earn $2.06 a share this year and $2.05 a share in 2009.

But investors who can look past the current financial strife and ensuing economic fallout may, along with Buffett, be seeing the bargain of a decade in GE shares. The stock is down 16% since mid September and down 34% for the year. And since its peak in September 2000, GE shares are off nearly 60%, despite earnings and revenues that have nearly doubled since then and a dividend that has almost tripled.

"You're hitting ten-year lows on the stock, but the majority of GE's businesses are in great shape, with organic growth rates in excess of 8% to 9% and a dividend yield close to 5%," says Weld Butler, a portfolio manager at Harbor Advisory, in Portsmouth, N.H. "Stocks like GE you do not often get the opportunity to buy at what we consider attractive price-earnings ratios of 11 to 12 times earnings."

Although it has sold at a discount to Standard & Poor's 500-stock index for much of this year, GE has historically commanded a premium of 16 or 17 times expected earnings, compared with a P/E of about 15 for the market overall.

And the company has a plan. In the short term, GE is serious about protecting its gold-plated credit rating, taking steps to preserve capital and decrease the leverage on its balance sheet. For instance, GE Capital will reduce the dividend it sends back to the parent company from 40% of the unit's earnings to 10%. GE Capital will not add any other long-term debt to its balance sheet this year, and the company is suspending its share-buyback program.

The company froze its quarterly dividend at 31 cents a share -- ending a 32-year streak of increases. And by the end of next year, GE wants to whittle the finance unit's contribution to the company as a whole to 40% of profits.

The stock sale "enhances our flexibility and allows us to execute on our liquidity plan even faster," said GE chief executive Jeff Immelt.

Longer term, GE will benefit by shifting its focus to its other businesses, including the company's infrastructure business -- those jet engines, locomotives and windmills, not to mention nuclear reactors and equipment for oil-and-gas exploration and water treatment.

Furthermore, the infrastructure build-out of emerging markets and the push for energy efficiency everywhere are themes that bode well for GE.Other business segments include a health-care unit, which makes a variety of medical equipment -- think MRIs, CT scans, x-rays -- and NBC Universal, which brought us the Olympics this past summer.

The company has jettisoned lackluster businesses, including insurance and plastics. The flagship lighting and appliances businesses could be spun off next year.

Analyst Daniel Holland at Morningstar figures GE's banking business is worth about $6 a share, down from about $11 a share before financial-sector Armageddon. The combined value of the company's industrial businesses, which he expects to achieve annualized revenue growth of nearly 8% over the next several years, comes out to about $36 a share. That gives the stock overall a fair value of $42 a share -- nearly 70% above what it's trading at now, and 20 times expected earnings. That may sound incredible, but GE traded at close to 40 times earnings at its 2000 peak, and you have to look only to last fall to find it at $42 a share.

Whether -- and when -- GE returns to its former glory remains anyone's guess. But we're not about to second-guess the sage from Omaha. And it's hard to argue with Holland, who says the current share price "is a good value for a stock with a solid dividend and decent growth prospects. If you're looking for companies that could survive a hard time, GE is one of them."