Many General Electric (NYSE:GE) shareholders are happy that Immelt is gone and Flannery is in. Unfortunately, Flannery isn't being handed a well-run ship. Although investors have high hopes for Mr. Fix-it, not everything can be solved quickly. I believe that one such problem is General Electric's pension plans, which were underfunded by $31 billion at the end of 2016. While this is not an emergency, it is a problem that needs to be addressed sooner or later.
Another Word For Debt
While pension obligations are not called "debt," for all practical purposes they function as a form of debt. Instead of paying cash flow to bondholders, General Electric pays the beneficiaries. If you care about how much debt General Electric holds, then you should care about the company's pension deficiency.
Bloomberg recently called this a "hole in the balance sheet that keeps growing," and it is right. Since 2010, the funded status of the pension plans has deteriorated from -$9.3 billion in 2010 to -$31 billion in 2016.
While the funded status is getting worse, pension plans are not an immediate concern because unlike real debt, there is no pressure to address the shortfall since there is no imminent redemption at hand. Of course, should the shortfall continue to increase, eventually it will become a big problem. To see why the pension plans are of no immediate concern, we can refer to the total amount of benefits paid. In 2016, the company only paid $4.8 billion of benefits. Compare that to the company's massive cash balance of $42 billion at the end of Q1, and it becomes obvious why there is no short-term pressure to close the gap.
However, the pension shortfall will eventually become unmanageable if left unchecked, as the amount of benefits paid will increase every year as more workers retire. So just because the immediate cash outflow seems to be manageable, the underfunded status of the pension plans is by no means a problem that can be simply ignored.
Irony At Its Best
What I find ironic is that the company had bought back massive amounts of stock under Immelt ($21 billion in 2016), cash that could have been used to plug this pension shortfall; and now Flannery may have to undo his work to fix the problem. While it was difficult to say whether Immelt's vision would have worked back then, with the benefit of hindsight, I think we can all agree that the massive buybacks weren't such a good idea. So the focus on buybacks created this "growing hole" in the balance sheet, but now buybacks may have to be pared back in order for the company to fill this hole. Of course, I don't know what management will actually do, but unless they plan to be even more aggressive with the pension portfolio, which is already fairly aggressive with a 7.5% long-term return assumption, trimming buybacks is really the only way to slowly close this gap.
Although there is no imminent need to address the pension issue, it is an overhang that must eventually be dealt with. Benefits paid (i.e. cash outflow) will increase every year as more workers retire and the gap will continue to grow. I don't know what actions, if any, the company will take, but if Flannery wants to deal with this issue quickly, Immelt's buyback legacy may be in danger. If the company's massive buybacks were on your investment checklist, you may want to revisit if General Electric is still the company for you, though you may also want to revisit your entire thesis anyway.
Author's note: Click the "Follow" button beside my name on the top of the page to be updated with my latest insights. To learn more about the Core Value Portfolio, whose goal is to compound capital at 20% over the long term, I encourage you to read the introduction to my investment process. Premium subscribers get full access to the Core Value Portfolio.
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.