General Electric: 2019 Optimism Warranted?

Summary

• Larry Culp has stayed on message, but as a cautious investor, I have not seen much change from the Flannery line of thinking.
• Shares have quickly rallied towards Wall Street sum-of-the-parts expectations. With the discount likely gone, at the very least the easy money looks gone.
• At worst, new investors might lose patience when year-end 2019 will not show much change versus what was just reported.
• This idea was discussed in more depth with members of my private investing community, Industrial Insights. Start your free trial today »

It’s interesting to me to see some investors celebrate gaining a quarter after losing a dollar and that is essentially what has happened (or worse) for longer term General Electric (NYSE:GE) shareholders. While I laud Larry Culp for staying on message since his appointment to the CEO slot in October, I’d challenge investors to ask what has exactly changed in overall corporate direction. The message remains the same: “Delever the balance sheet, divest and/or IPO assets, strengthen the Power business”. This isn’t a fast shift and the market seemingly accepted 2019 as a junk year with little to no transparency on growth, earnings expectations, and restructuring and spin-off costs. Combined with Larry Culp saying that “I don’t think I would ever say, even on my last day, that we have found all the skeletons [in the closet]” (Source: Q4 conference call), I’m a bit surprised at the latitude the market is giving the firm heading into what will be, at best, an extremely tough transitional year. With shares now approaching what is widely viewed as the current sum of the parts, it’s tough to see upside potential.

Major Themes – Some Positive, Some Negative

No free cash flow for Industrial debt reduction in 2019

Analyst consensus is for about $14,700M in EBITDA this year. This already bakes in operational improvement from 2018 ($13,250M) just due to the take-out of costs versus organic revenue growth. Assuming capital expenditures stay flat and interest expense remains in line, this backs into industrial free cash flow in the $4,900M range on an adjusted basis. Not a terribly surprising number and one that will be pretty close to 2018 levels; however, this does not factor in the expected $4,000M capital contribution to GE Capital and any restructuring costs associated with Power. The $0.01/share dividend, while small, is still a chunky payout as well given the outstanding share count. Based on my modeling, the 2.5x net debt/EBITDA for target for the Industrial business will be a little elusive. Likewise, any hike in the dividend should be prudently pushed out until 2021.

Power Cost Take-Out Continues To Be Reactionary And Not Proactive

During the conference call, Culp sated that General Electric was “reviewing every single project and contract”. We've heard that before and General Electric has now reduced headcount in the division by 20% since the peak and has massively shrunk the operational footprint both domestically and abroad. Apparently, there is still quite a bit of meat on the bone to cut: $300M in overhead costs is on the chopping block. This is not the first time that this kind of initiative has been taken; General Electric ate billions of charges in 2017 and 2018 related to Power and has perpetually underestimated just how deep the market decline has been. Is there a risk that they eventually cut too far? After all, John Flannery – pulled from the Q4 2017 conference call – was right when he said:

But as we look - all the analyses we do show a 0 to 2% ongoing growth in the coming decades for electricity from gas power. So there's opportunity in this business in the franchise itself.

It seems that General Electric is adjusting down to 25-30GW of new demand as the new reality. This has been a years-long boondoggle with a revolving door of executives calling the market growth story wrong. Is there a risk they run the business too lean in pursuit of positive margin? I think there is. While I think the market focus has been on profitability in the division, actual gas turbine deliveries apparently bottomed in Q2 2018 at 5 units; they’ve doubled since then. While this is a far cry from the consistent 20+ deliveries in the 2016 market, I do wonder at times how a “right-sized” General Electric would respond to pops in demand if they occurred.

Wabtec Deal Restructure, Future Spin-Offs

Contrary to some views, the Wabtec (WAB)/GE Transportation deal is a net positive for the company. Yes, the changes to the structure of the deal are a net negative to shareholders: they get less of a share in the pro forma company and now have to eat the taxes on the spin-off.

However, what is good for shareholders is not necessarily what is good for the long-term health of the firm. This is a distinction that investors have to accept. The new deal structure will allow more access to capital via the sell-down of its stake over time. This also lends credence to the 2.5x leverage target being tough to reach. Investors have to ask themselves: Why did General Electric change the terms? The answer is to have more access to capital. Simple as that.

This has been a long-running issue. The company has often structured deals in recent years – or at least tried to – in a tax-advantaged way for shareholders. It adds unnecessary complication and has resulted in these quirky setups that have contributed to the convoluted balance sheet. If management truly wants to simplify and right-size its assets, it has to make harder decisions like this. While it runs contrary to current General Electric guidance, I would also like to see them wind down their stake in GE Healthcare to less than 50% to have those assets move on balance sheet.

The advantage that other industrial juggernauts like Honeywell (HON) or United Technologies (UTX) have historically had versus General Electric has always been the simpler to understand financials. I’ve long lamented the headaches that come with diving into General Electric financials: the market gave them a pass for far too long on this and the long fall from grace occurred because investors just were not aware of the embedded risk. This is why the “we have not found all the skeletons” comment from Culp mentioned earlier just sits so uneasy with me.

Sum Of The Parts Implies Low Value

*Source: Credit Suisse, February 1, 2019 General Electric coverage

Contrary to some of the sum-of-the-parts analysis that have been floating around out there on Seeking Alpha (many are a little iffy in my view), most sell-side estimates have moved into the $10-11/share range. Rather than show my own, the above model from Credit Suisse encapsulates a pretty fair look at valuation in my opinion. The differences between what other authors have posted on Seeking Alpha and the Credit Suisse model is the necessary air of conservatism and proper comp work.

This includes the capital contribution necessary to move GE Capital to 3.5x, a level that it believes brings GE Capital to not being a money drain; the $4,000M contribution in 2019 from the parent being one step of that. Investors tend to focus on the high value pieces that remain of GE Capital like GECAS while ignoring the drains. It also builds in a necessary cushion for more insurance markdowns, the GE WMC Mortgage settlement ($1,500M charge announced with Q4), and future fines from the SEC investigation.

The multiple at Remainco is also an area of dispute. Could the implied multiple at “Remainco” move up with time if Power stabilizes or returns to growth? Potentially. However, competitor Siemens (OTCPK:SIEGY) is trading at 9x 2020 EBITDA expectations despite higher margin expectations. To see any upward movement, I think we need to see more actual execution versus management promises. After all, long-term General Electric shareholders have heard this all before.

Takeaway

The rotation of ownership from retirees and income investors to those seeking deep value now seems pretty concrete. While I think there were some positives to take away from the Q4 earnings, I'm a little surprised at the reaction. Number one, I’m cautious on the beat – most of that came from GE Capital earnings and not the Industrial business. Given GE Capital will need a multi-billion dollar capital infusion next year, well ahead of most bearish estimates, it is tough to reconcile the segment having consistent profitability in 2019. I believe this is why there was a more positive reaction from smaller investors, who tend not to focus on earnings quality but just see a beat or a miss as a black and white event versus the skepticism that came from Wall Street. Personally, I’m neutral on shares and would not rule out working back into another short position here in the teens.

Analyst’s 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.