Possible Catalysts for Bottom in GE: Equity Raise and Getting Booted from the Dow

Saying that shares of one-time market bellwether General Electric (GE) have fallen upon hard times lately is surely an understatement. To see a member of the 30-component Dow Jones Industrial Average get cut in half in a year hardly ever happens, but that is exactly what has happened after the company fired its CEO, cut its dividend by half and projected that their long-time goal of earning $2 per share in 2018 was out of reach (profits this year will likely be around half that level):

┬áThe big question now is whether GE is a screaming buy and a contrarian value investor’s dream. Normally it would not be overly difficult to answer this question, but the company’s financial services unit shares little information with investors, making it essentially a black box. Aggressive accounting metrics, having been carried over all the way back from the Jack Welch era, make it hard for investors to feel comfortable with the business outlook, as reported “earnings” more often than not differ wildly from actual GAAP cash flow.

That said, at $14 per share (and a dividend yield above 3% after the recent cut) the stock could very well be forming a bottom. Two announcements could very bring out nearly most every possible remaining seller; removal from the Dow and an equity raise to sure up their balance sheet.

The former seems like a forgone conclusion, though the timing is unknowable. As a price-weighted index, GE already represents the small of the 30 components by far. The next lowest priced stock in the Dow is Pfizer, which fetches more than double GE’s share price. Other components such as Boeing, Goldman Sachs, and 3M are anywhere from 15 times to 24 times more heavily weighted in the index even when GE’s market value is roughly the same as 3M and higher than Goldman. It is hard to imagine GE staying in the Dow for another 12 months, and when a change is made, plenty of index fund selling will occur.

Although less certain, there is a decent chance GE seeks to shore up its balance sheet by issuing more common shares in order to reduce debt. Dilutive transactions like that typically are priced below the market price of the stock at the time, and folks like Warren Buffett would likely be interested in scooping up some GE stock 5-10% below market prices. Such a move could also signal to the market that most of the bad news that could occur is behind the company.

Of course, the stock may very well be low enough that even these announcements would barely move the stock down at all, but that too would indicate that the selling has mostly passed.

All of that said, I have yet to start buying GE shares aggressively, mainly because I cannot yet get comfortable with the accounting games they play. The company has said that 2018 earnings should be the trough and that roughly $1 of earnings per share is a very conservative forecast for the year. If I felt strongly that $1 was “trough earnings” I would have little problem paying 14-15x given how many headwinds the company is facing right now. But the big question is what $1 of earnings really means to GE management.

As the company seeks to shore up its balance sheet and sell off some smaller divisions, we may get more clarity about their financial condition. Getting booted from the Dow would unleash some of the last remaining sellers (passive index funds) and raising equity could be the first step in stabilizing the capital surprises. While GE is not the ideal contrarian investment, the situation is worth watching closely as sentiment has turned severely negative and a few last shows could be getting ready to drop soon.


With Boeing Trading For 28x Earnings, Is The Bull Market In A Melt-Up Phase?

I do not spend a lot of time on cyclical stocks and the industrials and materials sectors are not well represented in portfolios I manage. Lack of expertise is one reason, but another tricky part of investing in cyclical companies is that you need to have a decent sense of their business cycles and that is not easy unless you have some specific experience in the industry.

That said, sometimes I dabble when I can get comfortable enough with the company and stock price simultaneously. In early 2016 that combination was staring me in the face after a sell-off in Boeing (BA) prompted me to buy at prices as low as $105 per share. I do not even recall what the particular short-term Wall Street worry was at the time regarding Boeing’s prospects, but if you are going to feel good about the competitive positioning of a large U.S. manufacturer, BA has got to be near the top of the list (nearly impenetrable market share, minimal competition, and fairly predictable product demand).

In 2015 Boeing had posted GAAP EPS of $7.44 per share, up modestly from 2014 and a new company record. At $105 each, the beaten down stock in early 2016 was trading at a trailing P/E of 14x and had posted free cash flow in excess of GAAP earnings for four straight years. It was a classic situation of getting a great business for a very reasonable price.

Boeing shares snapped back quickly, reaching $135 in less than two months. Earnings for 2016 were estimated to rise modestly again, which put the stock at 18x current year earnings, or nearly a market multiple for a cyclical business that was on pace for a fourth consecutive year of record earnings per share. As a result, I rang the register and was pleased with a 20% gain in a very short period of time (the IRR on the trade was over 1,000%).

Today, nearly two years later, Boeing stock closed at $320 per share:









What on earth is going on here?

Company management projects GAAP EPS of $11.30 for 2017 (fourth quarter results are due out later this month), which would be 48% above 2016’s record level. Boeing is trading for 28x trailing earnings, versus the S&P 500 at 22x.

Since when do cyclical stocks earning peak margins trade at premiums to the overall market? Isn’t it usually the other way around? Don’t investors in cyclicals typically pay high multiples on depressed earnings and lower multiples well into the upswing of a business cycle?

Other cyclical companies have seen steep share price climbs lately as well:

This bull market is producing some oddities no doubt. Not too many people would believe that nearly a decade into this economic expansion Boeing would fetch a higher valuation than Google (based on 2018 earnings estimates – CB 1/12/18), but that is exactly the case today. What does it mean? It is hard to say.

Maybe investors truly believe we are in the early innings of the economic cycle and Boeing’s earnings are set to soar more than they already have. Maybe the computer algorithms have taken over and just bid up every momentum-driven stock, regardless of what history would tell you about investing in cyclical companies. Maybe we are entering a melt-up/bubble phase and this market will ultimately hit a P/E ratio of 25 or 30x, with the biggest companies benefiting most due to huge index fund inflows. Maybe putting on a long Google/short Boeing paired trade today will look brilliant five years from now.

Thoughts on Boeing’s valuation? Please share.

Full Disclosure: No position in Boeing at the time of writing, but positions may change at any time

Barrick Gold Pressured To Lift Hedges Despite Elevated Gold Price

Tuesday evening we learned that gold producing giant Barrick Gold (ABX) has decided to issue $3 billion in new common equity shares in order to buy back all of its remaining gold hedges, which are currently in the red to the tune of $5.6 billion.

In the company’s press release Barrick explained that investors have expressed disappointment that the company has hedged 9.5 million ounces of production below market values. Barrick claims such a fact has put pressure on its share price, and therefore seems to have concluded that lifting their hedges is good for shareholders.

The press release also included reasons why the outlook for gold was positive (as would have to be your view if you decided to lift out-of-the-money hedges), but is this really the best time to be lifting hedges? I’m skeptical about the timing of this decision and therefore am glad that I am not a shareholder in Barrick.

As you may have seen, gold prices have risen sharply in recent weeks (chart below) and now trade near $1,000 an ounce for the third time over the last couple of years. The metal never seems to stay over $1,000 for long, even in the depths of the credit crisis. Barrick has decided, seemingly based entirely on pressure from shareholders, to go 100% long on gold just as the metal is nearing its all-time high. I thought we were supposed to buy low and sell high?


Barrick is going to pay $5.6 billion to lift its hedges, which is the mark to market loss it has on the books right now. On 9.5 million ounces, that means the company is underwater by $589 per ounce and must pay that much to get out of them. That means Barrick is partially hedged at $411 per ounce with gold at $1,000.

Now, I am not saying that hedging gold at $411 per ounce makes a lot of financial sense in current times. I certainly understand that investors want to see them lift those hedges. After all, if you are long ABX stock, you clearly think gold is going to rise in price, and therefore would want to benefit if that view proves correct. Still, from a financial management perspective, Barrick is essentially buying at the top of the market.

Why not wait for gold to drop to $800 or $900 before lifting the hedges? That would be a “buy low” type of move and even buying at $900 per ounce would save the company $1 billion in cash, versus making this move right now.

The converse argument would be that gold might not trade back down to $900 or lower, but that seems unlikely. The chart above shows us that gold prices couldn’t even stay above $1,000 during the worst credit crisis we have ever faced. In fact, gold traded at $700 less than twelve months ago, at $800 earlier this year, and at $900 just a few months ago.

Gold is typically seen as an inflation hedge as well as a flight to safety when fear is the paramount emotion on Wall Street. We have clearly already lived through the scariest part of this recession. In addition, inflation is unlikely to rear its head anytime soon because firms have little or no pricing power with such a weak economic situation (consumers and corporations are cutting back whenever possible, and demanding low prices, thereby rendering near to intermediate term inflation risks mute).

This $5.6 billion long bet by Barrick Gold with the metal trading at $1,000 an ounce looks like a bad idea to me and I would not be buying gold investments right now. Unfortunately, it appears that the company was forced to act by its shareholders, who likely have a biased view of exactly where gold prices are going to go from here.

If I were running Barrick Gold I would tell my shareholders, “look, we understand where you are coming from, and will look to lift the hedges when it makes sense, but not when prices are approaching all-time highs. Maybe on a pullback we will take swift action.”

Time will tell whether this move pays off for Barrick’s investors or not. In the meantime I believe it is a good time to be cautious on gold.

Full Disclosure: No position in ABX at the time of writing, but positions may change at any time.

Strong Balance Sheets Make Hunting For Value Easier

During the last bear market (2000-2002) there were dozens of situations where individual stock valuations looked down right silly. This bear market will be no different, and long term value-oriented investors can take advantage of the fact that in times like these numerous bargains can be had, but most people are too afraid to take them.

A great way to find value in the market is to use enterprise values (market values after netting out the firm’s cash on hand and debt outstanding). Investing in companies with hoards of cash in the bank allow investors to get the operating businesses on the cheap. There are many examples of this, and I often talk about net cash positions of various stocks on this blog, but let’s use former Halliburton (HAL) subsidiary KBR (KBR) to show what I am talking about. I don’t own the shares, but it fits the description perfectly.

At $15 per share, KBR stock is down 66% from its 52-week high of $44 and sports a market value of about $2.55 billion. Earnings in 2007 were $1.08 per share, and are expected to jump to $1.72 this year and $1.98 in 2009. That quick glance shows that KBR appears to be a pretty cheap stock at about 10 times trailing earnings and less than 9 times current year projections, but KBR’s balance sheet tells an even better story.

As of June 30th, KBR had cash on hand of $1.85 billion and no debt outstanding. With a market value of only $2.55 billion, KBR’s enterprise value is merely $700 million. With $11 per share of net cash in the bank, investors who buy KBR at $15 per share are getting the firm’s operating businesses for the aforementioned $700 million, or only $4 per share. This for a company that has earned $428 million in operating income in the last 12 months.

A valuation of less than 2 times cash flow is truly silly, but in markets like the one we have right now, nobody really cares because they are too busy being concerned about overnight LIBOR rates and when the Treasury is going to start buying up assets from banks. What great news for long term investors who can seize on opportunities.

Full Disclosure: No positions in the companies mentioned at the time of writing, but positions may change at any time

Buffett Adds $3B of GE Preferreds, Still Takes No Equity Market Risk

Warren Buffett is stepping up to the plate again, buying $3 billion in 10% preferred stock from General Electric (GE), after adding $5 billion of Goldman Sachs (GS) preferred just days ago. Many are focusing on the confidence factor the Buffett moves suggest, which I agree with to a large extent. However, keep in mind that this second deal is just like the first in that he is not taking on any equity market risk by purchasing preferred stock. As long as these firms stay afloat, Buffett can’t lose a dime, regardless of where the common shares trade in the future.

Full Disclosure: Peridot was long shares of GE at the time of writing, but holdings can change at any time

Contrarian Call: 40% Drop in Boeing Shares Looks Overdone

The decline in shares of Boeing (BA) has been significant over the last year. The stock has fallen 40% from $107 to $64 as high oil prices force most domestic airlines into heavy losses. The market appears to be acting as though Boeing’s only customers are domestic airlines. If that were the case, one could certainly argue near-term earnings growth would be non-existent and the stock deserves the severe haircut it has seen (BA trades at 12 times trailing earnings, 11 times 2008 estimates, and 9 times 2009 estimates).

Boeing – One Year Chart:

Investors need to keep in mind that Boeing will get 50% of its revenue from its Integrated Defense Systems (IDS) division this year, with the rest coming from commercial aircraft. The growth in the aircraft segment is coming from overseas, not the United States. With global economies growing faster than ours, much of the 95% of the world population not living in the U.S. are beginning to either fly more or fly for the first time. Countries like China, India, and the UAE are ordering more and more places from Boeing to boost their fleets. Boeing is not a one trick pony by any means.

The company has also been hit due to delays in its new 787 Dreamliner, its next generation plane. Wall Street obsesses over short term events, so a delay of a few months will hit the stock, but in reality, long term investors should feel confident that Boeing has a new product cycle coming. New planes cost more than the old ones and the 787 improves fuel efficiency dramatically, which is a great feature with high oil prices. Even with some delays with a project this big, Boeing’s earnings should still accelerate after the 787 starts being delivered.

Boeing appears to be an excellent contrarian investment option after a 40% drop in stock price. There are clearly issues facing the company, but the current valuation, I believe, has factored in most of the negativity. Even if 2009 profit projections turn out to be too optimistic (current consensus is $6.93 per share), the stock looks very cheap. Even if earnings only reach $6, Boeing at $63 trades at only 10.5 times forward earnings and yields 2.5%. That is a pretty meager valuation for a company that, combined with Airbus, dominates the aircraft market and has a strong defense business in a volatile geopolitical climate.

As a result, Boeing will be added to the Blog Model Portfolio after the market close today.

Full Disclosure: Long shares of Boeing at the time of writing

General Electric Earnings Could Initiate Oversold Bounce

General Electric (GE) will be the first important report of second quarter earnings season. After last quarter’s shocker, a stabilizing picture at the industrial conglomerate could very well help this market get a much needed and long overdue oversold bounce. With sentiment so low right now, even generally in-line earnings might be enough to halt the market’s slide.

Coming into this earnings season, consensus estimates call for S&P operating earnings of $88 for 2008. Interestingly, that would match the market’s 2006 level, and represent an increase of 6% over 2007. A huge headwind for the market has been the fact that earnings estimates coming into the year were way too high and downward revisions have been continuous. Stock prices will have a hard time rebounding until earnings stabilize.

Amazingly, estimates for 2009 are still way too high. Analysts right now are sitting at $109 for the S&P 500 next year, which I think is insane, quite frankly. If those numbers prove accurate this market will be off to the races by the first half of next year. That aside, if second quarter earnings are okay (not far below current estimates) hopefully we will get another short term oversold bounce, much like the two we have already seen during this year’s market ugliness.

A better report out of General Electric would go a long way to getting the ball rolling in that direction (GE reports before the market opens on Friday).

Full Disclosure: Peridot clients were long GE at the time of writing

Large Caps on New Low List

In addition to Verizon (VZ), mentioned in my last post, there continue to be attractively valued large cap stocks hitting new lows in the latest market drop. Both of these names sell for about 13 times this year’s earnings and 12 times next year’s estimates. Pretty cheap valuations for both of them.


General Electric (GE) ~$30

Fortunately for those who have owned the stock for a while, the days of investors paying 30 or 40 times earnings for this industrial conglomerate are over. With a far more reasonable valuation at hand, investors can actually get some value out of GE shares. Due to the company’s high exposure to financial services (they lend money to many big ticket customers to aid in financing equipment purchases), GE stunned analysts by missing first quarter earnings estimates and ratcheting down its outlook for the full year. As a result, GE shares made new lows under $30 per share, yield a dividend of over 4%, and now trade at a discount to the overall market.GE followers are used to the stock fetching a premium to the market, but value investors finally have an intriguing market bellwether to consider adding to their portfolios.

Microsoft (MSFT) ~$27

The Yahoo hangover seems like it will never end, but it will at some point this year. Before the Yahoo offer was made, MSFT’s business was clicking on all cylinders and the shares had reached the mid thirties. We can argue whether getting Yahoo would boost MSFT’s financials or not, but even if we assume no incremental benefit one way or the other, it is hard to make the case that MSFT shares are only worth 27 bucks. Either way, a move back into the thirties is likely. While it would happen pretty quickly if Yahoo finally decided to remain independent and the end of the saga finally arrived, even a MSFT/YHOO combination would likely result in a higher stock price in the intermediate term, as Yahoo has little bargaining power to extract an excessive purchase price above the $33-$34 offered previously.
Full Disclosure: Peridot clients are long shares of the companies mentioned at the time of writing

Backlogs Are Overrated

Just a quick note before I head out for the weekend. In the face of oil peaking at $135 per barrel in recent days we have seen many of the airlines cancel planned deliveries of new planes they were going to add to their fleets over the next few years. Those plane orders are now unnecessary as the carriers are cutting capacity.

The big point here is that investors often go gaga over industrial suppliers’ backlog. The longer the backlog the more predictable their revenue stream over the longer term, or so the investors would have you believe. Due to long lead times customers do have to place orders far in advance, often years ahead of time. Hence, the suppliers report their backlogs to investors to give them an idea of future business.

All of this appears to be very important, except for the crucial point that a customer (an airline for instance) can simply cancel their orders whenever they want since they are not binding. A large backlog may look really nice, until customers start canceling orders.

Now, would I prefer a large backlog to a small backlog? Of course. That said, I think backlogs in general are overrated on Wall Street since the orders are not binding. As a result, backlogs don’t always translate into revenues.