Monday, February 26, 2007

Calls of Note Part 2

- Merrill Lynch thinks one of the cornerstones of the bullish investment case for General Electric (NYSE:GE) is grounded in "reversion to the mean" theory (ie, as long as the earnings continue to increase the stock should eventually work). Firm thinks this argument potentially misses the point that lower earnings quality due to low tax rates and other items could incrementally negatively pressure GE's valuation multiple.

Given GE's tremendous size, portfolio breadth and high weighting within several benchmark stock indexes, they think that GE should be appropriately valued on a relative basis vs. the market. As such, GE's 15.7 times (2007E) P/E, or in-line with the S&P 500, seems fair
considering the stock's historical ~1% average market premium. Firm notes that this premium was derived with 1990s trading data when GE Capital constituted a much smaller portion of GE's earnings - financial companies trade for substantially lower multiples vs. industrial companies.

ML examined the valuations for industrial peer companies that also have low tax rates. It
appears that these companies have traded for 15-20% valuation discounts over the past 2 years compared with firm's adjusted diversified industrial benchmark index companies that have higher tax rates. They continue to think that GE could face possible tax headwinds over the coming years that could justify a valuation discount. Thinks think this could contribute to dampened investor sentiment toward GE. Maintains Neutral.

Notablecalls: GE has gotten hit lately in a pretty bad way. The high-vol gains the stock saw in December have been wiped out. ML's call won't help the sentiment but I suspect it will eventually set the stock up for a bounce. While there is no rational way to explain this, it's just how the markets work. May happen as soon as today. One to watch.

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