By Gene Marcial
What to do with General Electric (GE )? You could have bagged huge profits, of course, had you purchased its shares when they tumbled to 37 on Mar. 22 -- when GE was in the midst of trying to acquire Honeywell. The stock has since climbed to 50, partly because the Honeywell deal seems to be all but dead.
True, that acquisition could have been a home run for GE over the long term. But the market, in its imprecise wisdom, usually frowns on the stock of a company that's acquiring another. And some investors were concerned that in spite of GE's optimism over Honeywell, the takeover could imply lower returns on capital over the near term.
But now that Europe's regulatory authorities have just about quashed the deal, an increasing number of market players are once again hailing GE as an undervalued premier stock.
OFF THE TABLE.
"We remain bullish on GE," even without Honeywell, says Sheelagh Thomson, analyst at Morgan Stanley Deal Witter. The acquisition would have added substantially to GE's valuation targets over the long run, the analyst says. But without Honeywell, GE could still sustain earnings growth rates in the mid-teens and continue to improve return on capital investment over the next three to five years, says Thomson.
And with the risks that some had associated with a Honeywell acquisition off the table, GE's price-earnings ratio could regain the ground it had lost in the past six months. Thomson is also impressed by GE Chairman and CEO Jack Welch's decision to walk away from the deal when the European Union Competition Commission pushed for a greatly watered-down transaction that seems to compromise the deal's risk-reward dynamics.
"The whole episode demonstrates the strict fiscal disciplines that guide GE's acquisition decisions," says the Morgan Stanley analyst.
What's next for the House That Jack Built? "GE has demonstrated that it wants a bigger presence in aerospace," observes Jeanne Terrile of Merrill Lynch, "whether it's via Honeywell or another acquisition." She thinks the whole Honeywell episode has been an opportunity for GE to study the dynamics of the aerospace universe and to figure out what segments it wants to focus on.
"Any future deal is likely to be smaller," says Terrile, who also rates GE a buy. She notes that Honeywell had a lot of unattractive baggage that it had inherited when it merged with the old Allied Signal.
It's reasonable to expect volatility in GE's stock -- with the EU likely to deliver its official, final word on the deal on July 12 and as arbitrageurs unwind their short positions on GE and long positions on Honeywell. It's estimated that the arbitrage-related short position in GE stock is about 100 million shares, or 1% of its shares outstanding and five times the stock's average daily trading volume.
After the arbs clear out their positions, the stock could drift lower, says Morgan Stanley's Thomson. But when the dust settles, he says, GE's valuation should once again reflect its industry-high return-on-capital performance. GE's valuation levels have always reflected what Thomson calls its "excess returns," the stock's return on invested capital minus its cost of capital. In 1990, GE's industrial businesses generated returns of about 8%, and the stock traded at a 12-month multiple on forward earnings of 13. By 2000, GE had more than doubled its returns, and its p-e expanded to the 35-40 range.
The Morgan Stanley analyst believes GE -- with or without Honeywell -- will sustain this range. Thomson has a 12-month price target of 75 for GE. He advises: "We would use any short-term weakness in the shares to buy the stock."
Marcial is BusinessWeek's Inside Wall Street columnist