GE - Work In Progress

Summary

• GE ended 2018 on a relative strong note as CEO Larry Culp is making progress with regards to simplification of the business, restructuring and deleveraging.
• The road of the recovery remains long as much more work remains to be done.
• I like the moves made by Culp, yet note that based on a reduced footprint, earnings power might be limited to little over a dollar in the medium term.
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GE (NYSE:GE) posted relatively solid fourth quarter results as it is making progress in its simplification process. Shares have seen a big rebound from recent lows as the company is making progress with regards to asset sales and industrial businesses continue to show modest growth. Nonetheless, the road to recovery is long and deleveraging limits earnings potential as well in the longer run. This means that I am looking to sell a small portion of my long position on further jumps in the share price.

About The Results

GE posted a 5% increase in fourth quarter sales to $33.28 billion. GE Capital had a ¨strong¨ quarter with sales up 60% to $2.48 billion, but this is really incidental. Core industrial sales were up 2% to $31.2 billion, in line with the full year growth number.

Strong results were reported by renewable energy with 28% reported growth, yet this is a lumpy business. Particularly impressive is the 21% growth rate reported by aviation and recovery in transposition (+24%), although the latter is merged with Wabtec (WAB) of course. Oil & gas showed 8% growth but this marks a slowdown amidst weaker energy prices in Q4, as a 2% growth rate reported by healthcare is not too impressive as well.

Power remains a big worry with sales down 25% although order intake suggests a growing order backlog. Lighting saw sales fall by 16% as well, yet this is a very small business of course. Added together, the industrial segment reported earnings of $2.62 billion vs. $2.77 billion in the year before. Power was responsible for nearly a billion in reduced earnings power, not offset in its entirety by strong gains in aviation and oil & gas. The capital business lost $86 million an operating basis, as this remains a continued worry. With overall sales growth being modest, it must be said that order intake was pretty solid across the board, suggesting industrial resilience could continue for a while.

The issue is that the combined $2.6 billion segment earnings of both segments do not come close to an earnings number on the bottom line as result of corporate costs, pension liabilities to be paid, as well as regular interest costs and taxes of course. Nonetheless, GE posted net earnings of $574 million, or $0.07 per share.

All About Flexibility

GE has made progress in trying to simplify the business and balance sheet. In November of 2018 the company already announced the sale of shares in Baker Hughes GE, while a recently revised deal with Wabtec for the transportation business is set to close as well soon. These two pending deals and shares being held in the respective firms represent roughly $10 billion in value at current levels, a sizeable amount of course.

There was more good news in terms of simplification as the company announced a $1.5 billion settlement with the DOJ to settle FIRREA investigations of WMC, in line with reserves held by GE regarding the matter. GE Capital furthermore sold $8 billion worth of assets in the fourth quarter, reducing its balance sheet to $124 billion. My assumption has been that GE Capital can be wind down with current equity capital, now standing at $11.4 billion, for a simple leverage ratio of 9%. This is not really realistic, as GE has made numerous capital contributions, even sees some in 2019.

Further divestments will weigh on the business with total industrial revenues coming in at $113 billion in 2018. Note that this number could fall once divestments are fully accounted. After all, transportation revenues come in at nearly $4 billion and oil & gas assets generate $23 billion in revenues. That makes for a pro-forma revenue base of $85 billion, once all divestments are accounted for.

The industrial business holds $21 billion in cash and $68.6 billion in regular debt, for a $47 billion net debt load. Including roughly $30 billion in pension liabilities, adjusted leverage comes in at $77 billion, although the real pension liability for 2018 still has to be reported with the release of the annual report.

However, a $6 billion pension contribution made during 2018 should ensure that this liability will drop over the past year. With $10 billion in investments to be monetised, net debt could be seen at $37 billion, or $67 billion including pension liabilities, assuming none of these liabilities are ¨divested¨ as well.

Mapping The Potential

Assuming GE Capital can be wind down without inserting more capital (which is not really the case for 2019), we are left with a $85 billion industrial business with some real strong points, including notably aviation, to a smaller degree renewable & healthcare and troubles at power.

Assuming the industrial business should be able to report real operating profit margins of 15% on $85 billion in sales, that works down to $12.8 billion in operating earnings. With net debt of $37 billion (on which interest is paid), I peg interest costs at $1.5 billion a year. Combined with a 15% tax rate, net earnings could be seen at $9.6 billion, or about $1.10 per share with 8.7 billion shares outstanding.

With EBIT seen around $12.8 billion and D&A charges running at $3-4 billion, EBITDA might come in at $16 billion, for a 2 times leverage ratio based on regular debt, and nearly 4 times if pension liabilities are included. With earnings power of $1.10 per share, I could see a route in which shares might trade at $15-$18 per share, although the business still has a lot of debt at such a point.

In October of last year, and following renewed dips in December, I have averaged down to $9 per share, as shares are now trading about a dollar higher. Consequently, I am happy to hold onto the shares for now given the potential, although I would be tempted to sell a portion of my position if shares jump to $11 and change.

Final Thoughts

Of interest on the conference call is the mentioning that sale/separation of BHGE, transportation and GE Healthcare can be worth $50 billion, which implies a $40 billion contribution from Healthcare, under the assumption that 50% of healthcare will be monetised, which implies a $80 billion valuation.

That sounds ambitious as GE Healthcare reported $3.7 billion in segment earnings on $19.8 billion in sales in 2018. Not assuming additional corporate costs or interest, and working with a 15% tax rate, net earnings of that business come in at just $3.1 billion, which makes the $80 billion valuation quite high in my eyes.

Comforting is that industrial operating margins will expand in 2019, with power flattening out, although restructuring costs will limit free cash flow conversion, while the company is guiding that 2020 and 2021 will see improved cash flow generation.

While these comments and comments about hitting the bottom might be welcomed, realise that despite multi-billion divestments, leverage remains sizeable, GE is shrinking a lot, and real improvements have to be delivered upon. All of this is needed to drive earnings potential and valuation multiple inflation from here, as that takes a few years to be realised and real operating excellence.

Analyst’s 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.

Long, but might sell on further moves higher