GE gas turbine. Source: CNBC
Financial markets continue to melt up, regardless of the performance of the economy or growth in corporate earnings. Fundamental analysis for stocks seemingly does not matter amid tax cuts and low interest rates. Price discovery for stocks like General Electric (GE) could be delayed for a while. The company has also been hiving off assets, which makes it difficult to ascertain its core earnings. Asset sales may not be able to mask the diminution of Power Systems, which was supposed to be a key growth engine. Moody's recently acknowledged that GE Power remains weak:
Moody's, for its part, noted the sale of GE's biopharma business to Danaher (NYSE:DHR) improves corporate liquidity, but performance at GE Power remains weak. None of that, however, qualifies as news for equity investors today.
The sale of GE Biopharma to Danaher a few months ago was eye-popping due to its sheer size. The $21 billion sale at 17x EBITDA will allow the company to pare debt and change the narrative away from its dismal financial results. In March 2019, just a month after the deal was announced, management divulged that industrial free cash flow ("FCF") for full-year 2019 could be anywhere from $0 to -$2 billion. Despite the sale, I believe GE remains highly-indebted.
GE's Credit Metrics After The Biopharma Sale
GE's core operations - Power, Aviation and Renewable Energy ("NewCo") - remain in the doldrums. NewCo's Q1 revenue of $15.2 billion was down 5% Y/Y. Aviation (up 12%) was the only segment that experienced revenue growth. Segment profit fell 19%, while segment profit margin of 10% was down 200 basis points versus the prior year period. If the economy has peaked then this could be as good as it gets for NewCo.
Sliding margins and deteriorating cash flow sound foreboding amid GE's $108 billion debt load. I estimate GE's debt will be at junk levels even after the GE Biopharma sale.
Debt/EBITDA measures total industrial debt and debt at GE Capital ("GECC"). Management prefers to measure industrial debt in comparison to industrial EBITDA; the company's target is 2.5x. Its target debt/equity for GECC is 4x. GE bull Daniel Jones believes having separate credit metrics for the industrial operations and GECC is appropriate:
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.
I disagree. In the second half of 2018, GE was forced to abandon its commercial paper program. GECC's funding costs subsequently spiked. Given the diminution at GECC, I believe GE's credit rating should be measured based on total debt/EBITDA.
- GE's Q1 2019 segment profits, less corporate eliminations, plus depreciation and amortization, were around $4.2 billion. I used this as a proxy for EBITDA.
- Its run rate EBITDA (Q1 annualized) would be $16.7 billion.
- GE's current debt/EBITDA would be around 6.5x.
- GE is expected to forego $1.3 billion of Biopharma EBITDA and pare $21.4 billion of debt (assumes no tax leakage).
- This would leave GE with proforma EBITDA of $15.4 billion and debt of $86.1 billion.
- Proforma debt/EBITDA would be 5.6x, which could be considered junk status.
A metric at or above 5.0x would usually be considered below investment grade. The Biopharma deal will add liquidity to GE's balance sheet, yet the company's debt/EBITDA would still equate to junk status.
Gordon Haskett analyst John Inch recently questioned whether the Biopharma deal was in jeopardy amid a weak life sciences market. Life sciences equipment supplier Agilent (A) lowered its full-year sales guidance. This could portend a deteriorating life sciences market that could negatively impact Danaher and GE Biopharma. If a weak life sciences market prompts Danaher to cut the sale price or kill the deal, then it could prompt the rating agencies to revisit GE's credit metrics.
If a deteriorating life sciences market jeopardizes the GE Biopharma deal, then it could cause the rating agencies to look askance on GE's credit rating. A ratings downgrade could amplify GE's debt costs and sink the stock. 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.