GE: Don't Scoop Up Shares Just Yet
Summary
- Jeff Immelt Unofficially Talked Down Guidance Yesterday At The EPG Conference.
- Tougher Markets Were The Cause Despite An Improving Global Economy.
- Sell Side Analysts See More Bad News To Come.
GE isn't a growth stock. Since the peak in 2007, the stock price is down 35% and in this 10 year period, the average revenue growth has been -2.75%. Clearly, long term investors are in for the yield and there are indications that it may be in jeopardy.
Yesterday, General Electric's (NYSE:GE) Jeff Immelt, addressed investors at the EPG conference in Florida, one of only two times he speaks to investors publicly each year. This year he dropped a bombshell. I'll paraphrase his speech with an edited version of the transcript.
I don't think we do you any favors unless we underwrite 2018 assuming resource markets are stable. If you do that as your underwriting case $2 should be at the high end of the range and our job now is to take more cost out...we do think the digital spend as a buffer as markets potentially get worse, that's how we think about the company going forward.
The EPG comments are a great concern for two reasons:
- Because negative earnings revisions flow through to the dividend over time and threats to this stream of cash flows will directly increase selling pressure.
- GE's CEO has stated that the company is less likely to meet the financial hurdles that it has set for itself, not hurdles set by external analysts. This type of revision can signify an inflection point in profitability.
Despite the attractive 3.5% yield the financials are stretched to pay this amount. Since 2012, the dividend payout ratio rose from ~50% to over 100% (data from to Morningstar). The American Association of Individual Investors suggests that a payout ratio of over 50% is a warning sign but simple math tells you that a payout ratio of over 100% of earnings simply isn't sustainable and while the payout ratio improved from 2015 to 2016, it remains higher than 100%.
This isn't the only concern with the financials however. As the sell side points out, there is a disconnect between the company's ability to generate revenue and convert it to cash. Looking at the financials below, you can see revenue growing but the company's ability to convert it to cash decreasing rapidly. In 2016 for instance, the company grew revenue by 5% but was unable to generate ANY operating cash despite generating $20 billion off of a lower revenue number the year before.
Any of these three issues causes fundamental concern. But combined, a rational investor needs to approach with extreme caution. Combined we have a company with deteriorating cash conversion, an unsustainable payout ratio and management seemingly being surprised by something that caused the CEO to "talk down guidance" in a public forum. This is bad and the sell-side analysts that have recommended selling aren't going to let people forget their positions.
Consider this quote from Deutsche Bank analyst, John Inch, who currently has a "Sell" rating and a $24 price target:
We believe investors had expected GE to abandon $2.00+, the company kept $2.00/share at the high end of its 2018 framework - dependent on additional cost contingencies. We believe $2.00, up > 21% yoy, to be unrealistic, even as just a high point in the range. In turn, assuming GE does not present a 20c + 2018 EPS guidance range, the company's framework for earnings remains too high, in our opinion.
If the company guides down, he will clearly take a victory lap and raise the concern over a dividend cut and Deutsche Bank isn't the only firm with an unfavorable rating. JP Morgan analyst, Stephen Tusa, highlighted his "Underweight" rating as well:
We come away from the GE presentation at EPG with reinforced conviction in our UW call.
He then goes on to say:
Management kind of walked down the $2 target though stopped well short of a "reset". More importantly, they provided a framework around future FCF that comes in below our Street low estimate, and substantially below what we have seen from Bulls, reinforcing our view that the current run rate is less "depressed", with no V-shape in store.
No "V-shape" in store? Clearly he doesn't think this is over and any point of weakness the company shows, either real or imagined will generate a report that acts as a negative catalyst for the stock.
Clearly GE is here to stay and there is no reason to think the stock is broken. However, if you are holding shares, you need to realize that the barrage of negative sell side reports is starting not ending, consider the possibility of a selloff after a guidance cut and be prepared for a dividend cut if fundamentals don't improve in the next few quarters.
Although this article may not convey this thought, I am a fan of GE, the company. However, investing is all about timing and there may be a better price to buy GE shares.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.