The worst thing for General Electric (GE), besides an unsuccessful restructuring of its power business, would be a U.S. recession that starts to hurt its other core businesses, especially Aviation. Since downside risks have risen significantly in the last couple of weeks, I am reducing my exposure to General Electric in order to correct my GE overweighting. Though shares are far from being overvalued today, and General Electric has guided for improving free cash flow and margins going forward, risks are tilted to the downside.
Investment Thesis Update: Growing U.S. Recession Risks
General Electric pulled in $113.6 billion in industrial revenues ($105.2 billion when revised for the impact of dispositions) across multiple business segments in 2018.
As part of its portfolio restructuring, General Electric will report earnings for four major businesses going forward: Aviation, Renewables, Power and Healthcare, all of which are multi-billion revenue businesses and, with the exception of the healthcare business, depend on strong economic fundamentals.
General Electric said last year that it was going to spin off its healthcare business in order to raise cash. The healthcare business is hugely profitable for GE, and the company said that it could monetize up to 50 percent in order to help its deleveraging efforts. GE Healthcare is a $20 billion a year business (on a revenue basis) and contributed $3.7 billion in profits to General Electric's bottom line in 2018.
General Electric is still a moderately diversified conglomerate play (despite asset sales) with deep reach into everything from power plants to aircraft engines and diagnostic equipment. Hence, General Electric can be viewed as a proxy for the global economy: If economic growth slows, the probability of which has dramatically increased throughout May, General Electric is most likely going to see a negative earnings impact.
The single biggest change in my investment thesis with respect to General Electric relates to a significant change in U.S. trade policy last month. The U.S. and China slapped new tariffs on each other after a relatively long period of calm, which is poised to hurt economic growth. Further, new tariffs on Mexico are set to go into effect on June 10, 2019, which would further hurt trade, consumer and business spending, and, most likely, investor sentiment.
Until now, the stock market has essentially shrugged off new tariffs, even though they tend to have a stifling impact on economic growth. Higher tariffs raise concerns about the runway of the U.S. economy and are a potential catalyst for wholesale earnings revisions. The Fed tried to calm markets and fearful investors and implied that it was ready to cut rates in order to promote economic growth.
The worst-case scenario for GE would be a U.S. recession that hits home in 2020, just when the company projects a free cash flow recovery. A recession could seriously delay GE's turnaround and hurt prospects for share price appreciation.
The latest sign that an economic slowdown may be in the cards can be seen in Friday's employment numbers: Just 75,000 jobs were created in May, while the consensus was for 180,000 new jobs.
Power And Aviation Business
Two of General Electric's businesses may give reason for concern going forward: 1. The Power business, which GE is still in the midst of restructuring amid poor revenues and declining margins; and 2. The Aviation business, which, at least for the time being, is General Electric's bright spot in terms of revenue/earnings growth and margins.
As far as the Power business is concerned, it is far from being in shape right now. Revenues, margins, and earnings all slumped in the first quarter 2019 amid weak industry fundamentals.
Aviation, on the other hand, has seen the strongest growth in equipment and services orders of all businesses (equipment orders +23 percent, services orders +6 percent on strong commercial engine performance).
Source: General Electric
As a result, General Electric's Aviation business has been the best performing core business unit for GE in the first quarter, posting double-digit year-over-year revenue growth and healthy margins in excess of 20 percent.
Since risks of a U.S. recession (trade tensions, inverted yield curve, potential end to the current rate hiking cycle) have greatly increased since May, a downturn in the cyclical Aviation business would be a major red flag for the investment thesis.
General Electric's shares are not overvalued, so the decision to reduce my investment in GE was not an easy one. GE, theoretically, has the highest potential for a multiple re-rating in its peer group of industrial conglomerates.
Source: Achilles Research
What To Look Forward To
I expect General Electric to consider other asset sales and pursue a separation of the oil field service provider Baker Hughes shortly in order to raise cash and shore up its balance sheet. The company will be busy restructuring its vast Power business over the next 12-18 months, and, according to GE's turnaround plan, management expects an improvement in Power fundamentals (positive free cash flow) in 2021. Anything that points to an unsuccessful Power restructuring and/or delay in the FCF turnaround would likely hurt investor confidence and could result in another sell-off.
Market risks are tilted to the downside as investors continue to be in denial of a trade war that is poised to negatively impact global economic growth. Additional tariffs on Mexico, set to go into effect next Monday, will further hurt U.S. companies and have the potential to set back trade. After a more than ten-year economic expansion, a recession is more than overdue. In light of my overweighting of GE, I am scaling back my exposure to the industrial company in order to account for heightened downside risks.
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.