In this video, I show how to use the online tools at IOITools.com to analyze the free cash flow profile of global industrial giant, General Electric. This video also shows how to calculate Net Expansionary Cash Flows (“Net ECF”) and Free Cash Flow to Owners, two owner-centric, cash-centric measures introduced in The Framework Investing: Applying Value Investing to the World of Options (2014, McGraw-Hill).
See also the replay of the YCharts conference call on GE as well as the YCharts Focus Report on GE, which you can find on the Resources tab of the YCharts site.
Here is a transcript of this video.
Welcome to the Intelligent Option Investing Video Series. My name is Erik Kobayashi-Solomon and I am the author of the Framework Investing.
Today, I?m going to take you through an analysis of GE using the online tools at IOITools.com.
This video uses only the first tool in the toolkit, the Company Analyzer. In the preceding video, I used this application to analyze GE?s revenues and profitability.
In this video, I?ll cover investment level, cash flow, and investment efficacy. If you haven?t watched the previous video, please watch that one first, then come back to this one?the analysis will make more sense to you if you do.
I?ll use the other tools to value the company, see what the option market is saying, and look at different investment structures in videos that follow.
Recall that we are using the Analyzer to find the right questions to ask, not because we think it will give us ?the answer.?
Before we dig in, however, this presentation should in no way be considered an offer to buy or sell securities.
Do be aware, though, that with regards to GE, I am talking my own book.[1]
Explanation of Net Expansionary Cash Flow
We left off in the last video just as we were about to start looking at GE?s investment program, which I measure through something called Net Expansionary Cash Flow or Net ECF.
Net ECF is any corporate investment meant to boost profit growth, as measured by OCP, in the future. Companies have various ways of making these investments, as I talk about in The Framework Investing.
The ?net? part means that we also look at how much money the company is receiving from selling off assets.
OCP minus Net ECF yields a measure I call Free Cash Flow to Owners, FCFO. I believe that FCFO is a much better way of looking at free cash flow than other methods.
Let?s take a look now at the Company Analyzer and see what GE?s Net OCF is.
Net ECF for General Electric
Investment calculations are the most involved, so let?s first walk through each of the line items.
Gross Spending on property, plant, and equipment or PP&E is just a financial statement line item on the statement of cash flows. It is always a negative value or, in rare cases, a zero. In GE?s case, it has spent an average of around 12 billion per year on this over this time period.
This Expansionary Capex Estimate is simply the Gross Spending on PP&E minus our estimate of maintenance capex up here. In 2008, -16 billion of total capital expenditures, of which an estimated 11.5 billion of that was cash spent on maintaining the business. That gives an estimate for expansionary capital expenditures of $4.5 billion.
Any time you see a positive number here, that means the company is underspending on maintenance capex. If this happened over a long period, it would be worrisome, but note that GE is only underspending maintenance capex in 2008 and 2009?the depth of the financial crisis.
Cash inflows from asset sales?including the sale of businesses?goes in this line and cash outflows from acquisition costs go in this line. Just eyeballing these two lines in GE?s case, we can see that on a net basis, its divestitures have been worth much more than its acquisitions over the last five years.
GE doesn?t have any inflows or outflows to JVs.
Last, we try to estimate the real cash cost of stock compensation schemes by estimating the amount of money the company will have to spend so to buy back shares it is issuing to managers. I won?t go into the calculation of this since it is in The Framework Investing, but suffice it to say that I count this as an ?investment? as well and call it “Anti-dilutionary stock buy-backs.”
When we net all of these ways a company invests in growth we come out with Net ECF.
Just looking at the numbers, it?s hard to see what is happening. Let?s flip over to the graph I posted here.
In this diagram, the blue columns are the amount of cash outflow and inflow?outflows represented by a positive number, inflows represented by a negative one. The black line, scaled on the right, shows what proportion of profits the company is spending on these investments.
This is a very clear picture of GE?s recent divestments?shown by the downward-facing columns in six out of the last seven years.
There is one other way I like to look at the composition of this investment spending. I?ve linked that graph here on the Company Analyzer page as well under the title ?Capex Composition?.
Here, the red columns represent asset sales. These values are balanced out by t
he various categories of investment spending.
he various categories of investment spending.
This dark blue column represents capital expenditures in excess of maintenance capex. This lighter shade column shows cash acquisition costs, then the lightest shade in this graph is what I term ?Anti-dilutive stock buybacks?. Even though this column looks very small in comparison to the other categories, we estimate that GE is spending anywhere from $1.5 to $2 billion of shareholder capital per year to pay its executives in this backdoor way.
Now that we have a good idea about GE?s investment spending, let?s take a look at Free Cash Flows to Owners.
Free Cash Flow to Owners
FCFO is simply profit?as defined by OCP?minus Net Expansionary Cash flow. So in 2008, $37 billion of OCP was generated and $26.6 billion of investments made, implying $10.5 worth of FCFO. Compare this to nearly 38 billion worth of FCFO generated last fiscal year. This is an astounding CAGR of 29%.
We can see that FCFO Margin for GE has gone from 6% in 2008 to 26% in the most recent year, and also that 2013?s FCFO is at an historical high level.
I have graphed FCFO and linked it here, so let?s take a look.
As usual, blue columns are scaled on the left and represent actual dollar values. The black line is scaled on the right and represents FCFO margin?FCFO as a percentage of revenues.
In the last video, I hinted that I was not so concerned about GE?s falling profitability. You can see why by comparing this image of FCFO with the graph of GE?s OCP here.
You can see that OCP and FCFO are heading in opposite directions. In a sense, GE is selling some of its profits in order to buy more cash flows for its owners.
Now that we have seen FCFO, let?s take a look at Investing Efficacy.
Investment Efficacy and Summary
In The Framework Investing, I explain why comparing a company?s profit growth to the nominal growth of U.S. GDP is a good idea. If we look at that data here, we see that nominal US GDP has grown at an average 3% per year over the last five years, in comparison to a drop of 13% in GE?s profitability.
Again, because GE has been making such large divestments, I do not believe that this measure of Investment Efficacy accurately reflects GE?s potential.
GE was one of the original Dow Components back in the late 1800s, and is a Dow Component today. This suggests to me that the company has a history and a tradition of making wise business choices.
A company that invested poorly would not have survived for 120 years.
Okay, let?s sum up what we know about GE?s investments.
First, GE?s strategy reshuffling is affecting its investment profile. Disinvestments have been more prominent than investments and in a sense, the company is trading profits for cash flows.
Also investment efficacy appears weak, but I think this is an artifact of the strategic realignment. This transitionary period is mostly done, and in the next video, I?ll explain why I think GE is well positioned to grow now.
Last, I mentioned this in the last video?you can read more in-depth commentary about GE in my YCharts Focus Report.
Thanks for joining me for this video. Join me for my next video, where I?ll use the IOI Fair Value Estimator to generate a fair value range for GE.
Disclaimer
Framework Investing, LLC does not act in the capacity of a Registered Investment Advisor. As such, all information provided herein is for information purposes only and should not be considered as investment advice or a recommendation to purchase or sell any specific security. Security examples featured are samples for presentation purposes and are intended to illustrate how to use methodology explained in The Framework Investing: Applying Value Investing to the World of Options (2014, McGraw-Hill) in the analysis of the valuation of public securities. While the information presented herein is believed to be reliable, no representations or warranty is made concerning the accuracy of any data presented.
This presentation is not intended as investment advice, nor is it an offer to purchase or sell any specific security.
Disclosure
Mr. Kobayashi-Solomon initiated a beneficial ownership position in the stock and options of General Electric IOI, LLC undertakes no responsibility to update our clients regarding changes in the existence or size of Mr. Kobayashi-Solomon?s investment position in General Electric?s stock or options in the future.