Is GE Power Fixable?

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About: General Electric (GE)
by: James Coleman
Summary

GE stock was the second-worst performer in the S&P 500 in 2018.

The stock price has plummeted by ~40% since H. Lawrence ("Larry") Culp, Jr. was named CEO on 10/1/18.

GE Power's staggering $631 million loss for the quarter ended 9/30/18 is a major reason why the stock price fell by 57% last year.

Investment thesis

Uncle Ben’s admonition in Spider-Man that "with great power comes great responsibility" accurately defines the current status of General Electric (GE) CEO H. Lawrence (“Larry”) Culp Jr. As the first outsider to lead the iconic 126-year old conglomerate, Culp is faced with the daunting task of “fixing” the company, which incurred a monumental loss in the quarter ended 9/30/18, principally because of a goodwill impairment charge of $22 billion before tax, related to GE Power. The purpose of this article is to present a “12-Step Program” to help “fix” GE Power for the company’s review and consideration.

The author invites any and all comments about this article in an effort to engage meaningful dialogue in this regard.

Recent developments

The author’s viewpoint that Culp did “a commendable job of addressing the issues discussed” at GE’s 2018 Q3 earnings webcast on 10/30/18 was not a sentiment shared by the authors of a WSJ article whose harsh criticism said that “he fumbled a task straight out of Executive Leadership 101.” They also noted that GE stock sank 10% and traded below $8 for the first time since the financial crisis.

It is of utmost importance that Culp makes a favorable impression when he hosts the company’s 2018 Q4 earnings webcast on 1/31/2019.

Discontinue financial engineering practices

An excerpt from the 2017 10-K states, “In order to manage short-term liquidity and credit exposure, GE sells current receivables to GE Capital and other third parties in part to fund the growth of our industrial businesses.” The company should discontinue this practice as it relates to GE Capital, since it has no meaningful benefit going forward because GE has disclosed its intention to sell the bulk of what’s left of GE Capital. It also needs to discontinue the practice of making modifications to existing customer contracts as a means of adjusting profitability assumptions to support the stock price. In the author’s view, the SEC investigation will result in a sizable decrease in contract assets unless GE can provide an audit trail justifying these changes - which, in his view, will be challenging.

However, implementation of this recommendation may be considered a “good faith” effort on the company’s part to remediate past practices

Measurable metrics and specific timeline for remediation

Given the host of headwinds facing GE Power, it is incumbent that the reorganization of the unit involves realistic and specific metrics for remediation of identified issues and a specific timeline for achieving those goals. GE CEO Larry Culp has stated there will be seven discrete P&L centers going forward, which will allow the respective department heads to proactively deal with material variance differences between budgeted and actual results. Former GE executive John Rice has been tasked to run the newly created GE Gas Power Business, and will report directly to the CEO. The existence and use of accurate and timely information are critical for management planning purposes as the company advances its stated mission to “right-size” GE Power. Frankly, the author considers it borderline incredible that GE apparently does not already have granularity in this regard.

Perhaps the real intent and value of this reporting change is to send a loud and clear message that Culp wants to be totally up to speed in this regard.

A moratorium on quarterly guidance is needed

Based on the reorganization of the Power unit, and the numerous uncertainties regarding the timing of proposed divestitures of GE Healthcare, the author’s view is that GE should invoke a moratorium on quarterly guidance regarding cash flows and earnings for the foreseeable future. The company has clearly done an appallingly poor job of forecasting this critical information, and its decision not to update guidance on the Q3 earnings call is proof positive that much more rigor needs to be devoted to this effort. CFO Jamie Miller’s totally unexpected announcement on 10/30/18 (literally 10 months into the fiscal year) that the company would “significantly miss previous cash flow and earnings targets for the year” clearly shows how remiss GE’s financial handlers have been in this regard.

Increase transparency and declutter financial reporting

The author believes that high-quality financial statements are very clear, easily understood, candid and frank as articulated by the AICPA. The former CEO promised easier and simpler accounting going forward, and this should be a high-priority item with Larry Culp. Communicating material company information via a LinkedIn blog, as Russell Stokes did, regarding the “teething issue” which GE has since said may end up costing the company almost $500 million is simply unacceptable and unprofessional. The author hopes that the new CEO utilizes the resources of GE’s communication unit as the preferred and proper venue for informing stakeholders of relevant information.

Comprehensive review of GE Power portfolio

GE should commission a comprehensive review of GE Power Portfolio led by Russell Stokes (whose GE.com profile and LinkedIn.com info, for some inexplicable reason, still lists him as CEO, GE Power) This effort would be enhanced by the involvement of GE’s internal audit staff and the input of the company’s “tiger team” in order to determine whether any part or all of this unit should be divested.

Headcount reduction

In 12/17, GE stated that it would “reduce our global headcount by approximately 12,000 positions.” The 2018 Q1 earnings call presentation included a slide that the company is “on track for 12K headcount reduction.” There was no mention in the 2018 Q3 earnings webcast presentation regarding the progress of these headcount reductions, so GE’s new CEO has not weighed in on this issue, especially as it relates to present and future RIF numbers. In the author's view, this lack of communication is troubling and needs attention as soon as practical, especially since the company has clearly stated that this issue was an integral part of its 2018 cost out plan to “right-size” GE Power. It is the author’s view that given the significant downturn in the turbine market, it appears that a layoff of a minimum of an additional 4,000 workers may be necessary to “right-size” the division.

GE toolbox

The author believes that an “all hands on deck” approach is key to a successful turnaround of GE Power, including but not limited to the involvement of the following constituencies:

  1. “Tiger team”
  2. Internal audit team
  3. Divestiture team
  4. Mergers & Acquisitions team

Although a discussion of specific “action items” for the respective teams is beyond the scope of this article, each group should have the opportunity to offer valuable contributions and help GE "make mission" regarding the turnaround of GE Power.

KPMG status

On 12/14/18, GE issued a press release announcing a "tender process" regarding its audit relationship with KPMG, which spans 111 years and for which the firm received fees of $140 million in 2018. The author is in favor of a change in audit firms because - among other reasons - he believes that there is a growing probability that GE and KPMG may ultimately develop an adversarial relationship, based on his review of a pending shareholder lawsuit. The ongoing SEC and DOJ investigations into GE’s accounting practices is also a growing concern, especially in the event that criminal charges are forthcoming.

Increase use of GAAP

GE’s entrenched history of "black box" accounting and financial reporting is legendary. CNBC’s Jim Cramer has gone so far as to say “GE has never played by the rules.” As a former CPA with significant audit experience, the author strongly believes that the company’s liberal use of “non-financial measures” is simply not helpful in many cases, and hopes that Larry Culp adopts GAAP accounting wherever practical.

Doing so would be beneficial to all users of the company’s financial reports.

Accountability

It is abundantly clear that the new CEO’s decision to reorganize GE Power (which was formed in Q3 2017) is key to turning around the company’s largest operating segment. Since a decision of this magnitude was made a matter of weeks after Culp was named CEO, it is patently obvious that he deemed the present situation at GE Power egregiously untenable. The “reassignment” of Russell Stokes is indicative of Culp’s dissatisfaction with Stokes' leadership role as the former CEO of GE Power.

Ring-fence Alstom for possible disposal

The author’s 12/31/17 article, “The NEW GE Power Faces an Uncertain 2018,” referred to the company’s $10.6 billion acquisition of Alstom’s power and grid businesses as “both grossly overpriced and ill-timed.” He also stated:

“An SEC comment letter recently made public directed GE to revise future filings to disclose how the company determines the amount of synergy progress for Alstom could potentially become problematic regarding the Goodwill amount of the Grid Solution reporting unit within the power operating segment.”

On 10/1/18, GE announced that it intended to take a ~$22 billion goodwill impairment charge, which effectively all but eliminates the goodwill associated with Alstom. Since it is now apparent that this acquisition was an unmitigated disaster, the author believes that GE should do a “deep dive” into the merits of divesting all or part of Alstom, perhaps on terms akin to the proposed Wabtec (WAB) transaction.

Operational

In the author's opinion, GE Power’s biggest operational challenge is the unit’s bloated inventory. The author’s analysis of GE’s most recent 10-Q indicates that the company’s plan to double power inventory turnover in 2018 has clearly failed miserably. The company’s 2018 inventory turnover ratio is virtually unchanged from 2017 and is well below its industry peers, per information sourced from the "Almanac of Business & Industrial Financial Ratios."

"Right-sizing" GE Power includes "right-sizing" its inventory to a level consistent with realistic sales metrics. Maintaining a realistic inventory level will have the added benefit of increasing cash flow and decreasing insurance, maintenance, storage and other related costs. It is critically important that GE address the deficiencies in its 2018 plan using a CPA’s audit approach and implement corrective action for 2019. In 2017, GE wrote off about $850 million of charges, slow-moving and obsolete inventory related to GE Power. Given the documented failure of the company to improve its inventory turnover in 2018, it may very well incur a similar charge this year.

Any such charge would affect both the company's statement of financial position and income statement, and further degrade GE’s precarious financials.

Conclusion

As a GE shareholder, the purpose of the foregoing narrative is to present a framework of ideas for the company’s review and consideration as it attempts to navigate the challenging landscape of today’s rapidly changing power industry. The author fully recognizes and acknowledges that GE’s leadership team will make decisions based on what they believe is in the best interests of all the company’s stakeholders.

2019 promises to be a watershed year for GE, and the author remains hopeful going forward.

Disclosure: I am/we are long GE. 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.