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GE Earnings: Don't Buy the Headline, It's a Miss

General Electric reported improved profit and an in-line bottom line in the third quarter, but earnings were helped by tax treatment and margins across key GE businesses were lower year over year.

GE earnings rose 57 percent to $3.22 billion in the third quarter, up from $2.06 billion a year earlier.

Per-share earnings fell to 22 cents a share from 28 cents due to a large dividend payout to Warren Buffett's Berkshire Hathaway , which was expected to hit this quarter; going forward it will add 3 cents back to GE earnings annually.

Operating earnings in the quarter were 31 cents a share, meeting the estimates of analysts.

If GE met expectations in terms of the 31-cent earnings, it was only on the surface. Jeff Sprague, analyst at Vertical Research Partners, noted in a premarket review of the GE results, "Headline looks OK, but it's a miss."

Sprague explained that industrial operating profit was 2 cents below his forecast on weak margins, but the lower operating results were offset by a lower-than-expected industrial tax rate of 17.6 percent versus his estimate of 21 percent and other below-the-line items. GE Capital net earnings were almost exactly on Vertical's estimate, but its tax rate was 3.7 percent versus the high teens GE was guiding. The lower tax rate contributed another 2 cents to earnings.

"Net/net the operating results were about 4 cents below our forecast and implicitly the same miss versus the Street," Sprague calculated.

Margins in core GE businesses remain under pressure as well.

Chris Glynn, Oppenheimer & Co. analyst, wrote in a premarket flash note, "Bottom Line: Visibility to Industrial revenue mix improvement remains a bit cloudy, and we await details ... Energy infrastructure operating margin remains a concern."

Vertical Research's Sprague noted that margins were down year over year in "the big four" industrial businesses. Energy margins were 14.3 percent versus the Vertical estimate of 18 percent and versus 20.4 percent last year. Oil and gas margins were 12.6 percent versus Sprague's estimate of 15 percent and 16.1 percent last year. Aviation margins were 17.8 percent versus Vertical's 18 percent estimate and 18.3 percent last year. Finally, health care margins were 14 percent versus Sprague's 15.2 percent estimate and 14.7 percent last year.

"These margin declines came on up revenues in every division underscoring our concern that there is little or no operating leverage in GE's portfolio due to low priced equipment in backlog and R&D headwinds," Sprague wrote.

On the earnings call, the issue of margin and pricing weakness in energy was keyed on by analysts. GE's Immelt said it was a "particularly tough" comparison year for energy margins. OpCo's Glynn asked how profit could be down in energy on 25 percent revenue growth.

GE said the wind business — which has been a margin headwind for several quarters — continued to be the primary driver of margin weakness, along with M&A impacts, plant revenue and global investments.

GE tried to spin a positive margin story amid the weakness. The industrial conglomerate said on the earnings call that with the energy margin profile, "we will improve off of where we've been this year, and directionally in what we are trying to achieve for 2012."

GE also noted that aviation margins will continue to be pressured in the fourth quarter as its ramps up its shipments of its GenX engines. "We've got a shot at expanding margins in aviation next year," Immelt said.

GE touted its record backlog in the quarter of $191 billion, but the Vertical Research analyst threw some cold water on this as well.

"GE Industrial orders were up 16% and backlog stands at an eye popping $191 billion. However, we believe very aggressive pricing is behind the order growth and flushing the backlog of poorly priced product is at least another 12-18 month process. In the meantime, GE will likely show little or no operating leverage in its businesses."

Oppenheimer's Glynn had noted ahead of GE earnings, "Industrial earnings lack meaningful cyclical leverage to a reaccelerating economy, given largely stable services growth and long-cycle equipment lead times."

For a stock that has had a difficult time moving any quicker than a glacier, this isn't likely the earnings that does the trick. GE shares were at a 52-week low on Oct. 2.

GE said in its earnings presentation that earnings growth and margin outlook are stronger headed into 2012, and it's positioned well in a "volatile market." But the initial read on earnings was less confident from Wall Street, if acknowledging that there was nothing dire in the GE report.

GE was sober in its assessment of margins and pricing headed into 2012, even as it spun an improving outlook. "What we've had to deal with in terms of margin compression in 2011 means we will still have price pressure in 2012," GE said on the earnings call.

A bank investor might play GE for its capital arm, but Vertical Research's Sprague had another conclusion for industrial sector investors: "While GE's earnings are gradually healing we see much more interesting industrial plays for exposure to energy and aviation."

GE would disagree, saying on its earnings call that when you look at its profile of businesses and opportunity to grow organically, it compares favorably to peers.

GE shares were down on Friday by more than 2 percent as the markets rallied strongly, up 2 percent on hopes for a Euro zone crisis resolution.

One of the biggest questions — and potential catalysts for GE shares — would be the reinstatement of a dividend from GE Capital to the parent company. There had been chatter on Wall Street earlier this year that the GE Capital unit might begin paying a dividend to the parent this year, but more recently, the conventional wisdom backed this event up to 2012. GE confirmed the hoped-for 2012 timeline on the earnings call, and gave its view of the challenges it faces in meeting this goal.

GE said on the call that as far as cash and capital allocation, it won't have the drag of not having the NBC Universal cash anymore as growth of industrial cash from acquisitions and growth in earnings offset the NBC Universal divestiture next year.

"Our plan is to have a dividend back from GE Capital to the parent in 2012. We have worked hard to get there, to strengthen our cap ratios," a GE official said on the call. However, GE noted one wrinkle in this plan is the recent Federal Reserve oversight of GE as a new financial regulator, which began during the summer. "It's early in the process for them to understand us, so the objective is still the same, and there is lot of work to do to get there. We expect to have lots of cash to allocate in 2012."

Immelt stepped in during the discussion of the dividend and Fed regulation to downplay the Fed's role in potentially holding up plans to reinstate the GE Capital dividend to the parent, saying that the GE dividend is key for investors and an "extremely strong" priority for GE and its board, separate from the issues related to Fed oversight.

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