General Electric: A Fixable Company And Situation
Summary
- The stock is up big since General Electric announced its CEO change.
- The struggles of the Power unit and the company's poor financial position have caused downward pressure for the stock but, in my opinion, General Electric is a fixable company.
- I plan to stay long General Electric. What do you plan to do?
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Long suffering General Electric (NYSE:GE) shareholders have enjoyed a nice ride since the company announced that Mr. Larry Culp, the former CEO of Danaher Corp, would replace Mr. John Flannery as CEO.
While shares are up big in such a short period of time, I still believe that the risk is currently to the upside, of course, over the long-term — that is, most of the bad news is already priced into the stock, in my opinion, so a string of positive developments would likely result in a significantly higher stock price. There are definitely risks that need to be considered/evaluated (will be discussed below), but I believe GE shares at the current level are attractively priced. Moreover, Mr. Culp appears to be the right guy for the position and he without a doubt has a proven track record but, in my opinion, it is somewhat easy today to overlook the fact that whoever is leading this industrial conglomerate has some great businesses to work with.
A Strong Portfolio Of Businesses
General Electric is a well-diversified company that has strong businesses in several key industries that have promising long-term prospects.
The company will, however, look very different after the following transactions are finalized:
- The Lighting unit is currently being shopped around and I expect for the business to be offloaded at some point in the near future.
- The company entered into a unique deal to merge its Transportation unit with Wabtec (WAB) to create a new publicly traded entity.
- The Healthcare unit spinoff is expected to close in 2019.
- The idea of selling or spinning off the majority stake in Baker Hughes, A GE Company (BHGE) has been floated.
- The company has expressed their intent to further reduce GE Capital's business in the years ahead.
After all of these transactions (and potential transactions), GE will be left with Power, Aviation, and Renewables. Yes, the Power unit is facing significant headwinds but, in my opinion, this business will eventually again be a promising asset. GE's management team will definitely need to properly position the Power unit but, as described in a recent article published by Deloitte, the changing environment will also create some opportunities. Specifically, Deloitte mentioned the opportunities that Power companies will have to benefit from increased demand over time, in addition to the efficiencies that will come with digitalization.
Simply put, the Power unit will be a drag for the next few years but that does not change the fact that this operating segment has great long-term business prospects. The global economy will always need power, right?
A Leverage Problem....That Is Fixable
GE's credit rating was recently downgraded by S&P and Moody's has the company on watch for a potential downgrade, and I believe that these negative developments make sense given the company's current financial position. To this point, GE had a large net debt balance as of June 30, 2018.
Source: June 30, 2018, 10-Q
The company also has an underfunded pension.
Source: Bloomberg
The rising rate environment and the additional contribution commitments that the company announced will definitely improve GE's underfunded status in the years ahead (for example, it is estimated that each 25bps increase in rates will reduce GE's pension deficit by $2.2B). Moreover, GE's pension position has already improved so far in 2018 but the company still has a lot of work to do.
On a positive note, when taking a step back, let's also not forget that GE has significantly lowered its debt balance since the company decided to reduce its reliance on its financing businesses.
So, yes, GE has a financial leverage problem but I believe that management has levers to pull to fix it. First, management should reduce the dividend to a more-manageable amount, which is a topic that I previously described here. Then, going forward, I believe that the asset sales have the real potential to put GE in a significantly better financial position. Not only will debt go with the asset disposals (for example, approximately $18B of liabilities will go with the Healthcare unit when it is spun off), but GE will also have the option to monetize the minority stakes that will be held in the newly created entities. At the end of the day, GE has a leverage problem but, in my opinion, this 'situation' is fixable.
Strong Backdrop But Expect Near-Term Pain
It is important to remember that labor numbers/GDP growth have been impressive over the last year and, according to FactSet, the companies of the S&P 500 are likely to report earnings growth of over 20% for the third straight quarter. GE is obviously highly levered to the companies of the S&P 500 so the strong earnings estimates should have a positive downstream impact on this industrial conglomerate. To this point, notice the bullish estimates that analysts have for the key industries that GE operates in.
Source: FactSet, Sept 2018 Report
Make no mistake about it, it is almost a certainty that GE will report a kitchen-sink type of quarter later this month. Furthermore, as I mentioned above, I really think that it is now time for GE's management team to reduce the dividend and focus their attention on strengthening the company's financial position. The stock, however, will likely face downward pressure if management reduces (or eliminates) the dividend and the company reports a kitchen-sink type of quarter, but I believe that these two factors have the potential jumpstart GE's road to recovery.
Risks
The pension deficit is always front of mind, and rightfully so, as the company is currently underfunded by well-over $20B. The pension deficit, coupled with the company's large debt balance, should be monitored in the quarters/years ahead but I believe that management will be able to position the company to service these large liability balances.
The SEC probe/investigation has the potential to be a game changer for this company. The fine is not the issue, but instead, what else the SEC will find is the real concern. Has GE been fudging its numbers for years? How exactly did the Power unit's profit fall so far so fast? GE stock will face further downward pressure if the insurance charge probe results in the SEC looking deeper into the company's past earnings results/disclosures.
Bottom Line
The market liked the fact that Mr. Culp's compensation package is heavily tied to stock performance and, in my opinion, the estimated $300M pay package will be well worth it if he can right the ship. As I have said multiple times before, GE is a three-to-five year story and none of the recent developments have changed this thought pattern. It will take Mr. Culp and team time to right the ship.
In my mind, a dividend cut and a kitchen-sink quarter would remove a major overhang for the stock. The company already lowered forward cash flow guidance and pre-announced an approximately $23B goodwill charge but I would expect more to come. Investing in GE today is risky, as there are a lot of moving pieces to factor in, but this industrial conglomerate has great assets/businesses in its portfolio if your time horizon is longer than 12-24 months. Therefore, I believe significant pullbacks should be consider long-term buying opportunities, especially if they are a result of a dividend cut or restructuring charges.
Disclaimer: This article is not a recommendation to buy or sell any stock mentioned. These are only my personal opinions. Every investor must do his/her own due diligence before making any investment decision.
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Disclosure: I am/we are long GE, BHGE. 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.