General Electric (GE) remains one of the most polarized names in the stock market. Bulls believe the value of GE's underlying businesses far exceeds its debt load and pension obligations. Bears believe the share price does not fully reflect the diminution of Power or its deteriorating cash flows. In October 2018, Moody's downgraded GE's senior unsecured debt two notches to Baa1. Moody's referenced the adverse impact of Power's deteriorating performance on GE's cash flows. Moody's also provided parameters for another potential downgrade:
Moody's suggested another downgrade could be forthcoming if (1) GE was unable to sustain free cash flow ("FCF")/debt at around 7% or (2) there was not a steady improvement of debt/EBITDA towards less than 3 times.
A few months ago the company sold GE Biopharma to Danaher (DHR) for an eye-popping $21 billion, or about 17x EBITDA. The transaction will allow GE to pare a sizeable chunk of its debt and improve its credit metrics. Bulls assumed GE's debt problems would magically disappear. That may not be the case.
GE Is Running In Quicksand
GE was put on notice about Power's performance six months ago. However, Power's demise has continued. Its Q4 2018 revenue fell 25% Y/Y and it reported another operating loss. CEO Larry Culp recently divulged Power remained a multi-year turnaround, and he expected negative FCF for 2019, mainly due to weakness at Power. This could give the rating agencies cover to downgrade GE again. Time may not be on the company's side as Power's disruption by renewable energy continues.
Analysts are worried about the consequences of a potential downgrade to non-investment grade status. Those worries could be well-founded. By my estimation, GE's total debt/EBITDA was at junk levels before the Biopharma deal; it will likely be at junk levels after the deal is completed.
GE Credit Metrics After The Biopharma Deal
GE's FCF has continued to deteriorate. Industrial FCF for 2018 was about $4.5 billion. It is expected to be negative this year so it would not meet Moody's expectations. I provided a table below to illustrate GE's proforma credit metrics (debt/EBITDA) after closing the Biopharma deal.
Debt/EBITDA measures total industrial debt and debt at GE Capital ("GECC"). Management claims its industrial net debt at year-end was $55 billion and its target net debt/EBITDA is less than 2.5x. It also wants to reduce GE Capital's ("GECC") debt/equity to less than 4x. GE bulls like Daniel Jones have bought into management's notion of bifurcating industrial debt and debt at GECC:
In all, $25 billion in debt should be reduced on the GE Capital side of the business, bringing leverage down to under 4 by next year, even as it pays its $1.5 billion WMC settlement and covers the $2 billion in annual insurance payments required of it. This compares to a net leverage ratio of less than 2.5 for the conglomerate's Industrial operations.
In my opinion, evaluating GE's debt is more of an art than a science. Under normal circumstances, bifurcating industrial debt and GECC debt would make sense. However, this is not a normal situation for GE. The company's funding costs spiked in Q4 2018 after it was forced to abandon the commercial paper market. I suggested the subsequent run-on-the bank would crimp GECC's profits, and I was loud about it.
GECC's 2018 segment profits were -$489 million. Larry Culp has not addressed (1) GECC's revised funding costs or (2) how badly its assets have been impaired. Given the diminution at GECC, I believe GE's credit rating should be measured based on total debt/EBITDA.
- GE's full-year 2018 segment profits less corporate eliminations, plus depreciation and amortization would be around $15.7 billion.
- This figure includes segment profits from GECC.
- GE's current debt/EBITDA would be around 7.0x.
- GE will forgo $1.3 billion of Biopharma EBITDA and pare $21.4 billion of debt (assumes no tax leakage).
- This would leave GE with proforma EBITDA and debt of $14.5 billion and $88.6 billion, respectively.
- Proforma debt/EBITDA would be 6.1x or junk status.
A metric at or above 5.0x would usually be considered junk status. GE's CEO has trumpeted the Biopharma deal. However, total debt/EBITDA still appears to be at junk status.
GE's debt appears to be at junk levels before and after the Biopharma deal. Another ratings downgrade could increase GE's borrowing costs and hurt sentiment. Sell GE.
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Disclosure: I am/we are short 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.