General Electric: The Markopolos Report Will Eventually Be A Net Positive

Summary

• General Electric's stock was performing well on a YTD basis before the Markopolos report was released.
• I believe that the Markopolos report will [eventually] turn out to be a net positive for long-term shareholders.
• I am long General Electric, and I recently added to my position.
• This idea was discussed in more depth with members of my private investing community, Going Long With W.G.. Get started today »

General Electric's (NYSE:GE) stock was performing well in 2019 before the Markopolos report was released to the public on August 15, 2019.

Data by YCharts

Two things to notice: (1) the significant drop in mid-August after the Markopolos report was published and (2) GE shares are still up almost 16% even after the recent double-digit decline.

I actually believe that the Markopolos report will be a positive development for GE shareholders, eventually that is. Additionally, I believe that shareholders with a long-term mindset should consider staying the course while this story plays out because GE shares still have significant upside potential if the fraud calls turn out to be incorrect (which I believe to be the case).

The Timeline, Is It This Or Is It That?

Not to rehash the already well-covered Markopolos report (see here and here), but, basically, the person that discovered the Bernie Madoff Ponzi scheme, Mr. Harry Markopolos, recently called GE the biggest fraud since Enron and WorldCom (now that is saying something!). The report, in my mind, boiled down to two major points: (1) GE's insurance reserves are not sufficient and (2) the accounting for the Baker Hughes (BHGE) transaction was fraudulent, and the company is "hiding" an almost $10B loss.

Source: General Electric, A Bigger Fraud Than Enron

I could go on-and-on about this report, but, instead, I want to focus on a timeline for how things played out since the fraud call first hit the wire:

August 15, 2019

• Mr. Larry Culp, CEO, called the fraud allegations "market manipulation" and questioned Mr. Markopolos' compensation related to the release of the report (an unknown hedge fund paid him for his "research"). Mr. Culp also put his money where his mouth was by purchasing 252k shares of GE after the Markopolos report was released (and this was after purchasing $3M worth of stock earlier in the week).
• Analysts from Citigroup and William Blair called the fraud charges "inaccurate" and noted that Mr. Markopolos' report had "sufficient shortcomings".
• Stanley Druckenmiller, a well-known hedge fund manager, bought GE shares after the sharp stock price decline. Mr. Druckenmiller was quoted as saying that "I believe Culp... I bought stock today".

August 16, 2019

• A well-known short seller, Citron, stated that Markopolos got it wrong and questioned the credibility of the report due to the related compensation. In addition, Citron was a buyer of GE shares on the dip.

August 19, 2019

• GE released a detailed rebuttal to Mr. Markopolos' report. The company pointed out where Mr. Markopolos got it wrong and explained in detail the sufficiency of the insurance reserves and accounting for the Baker Hughes transaction.

August 20, 2019

• Fitch Ratings listed GE as one of the riskiest insurers in the long-term care space.
• After completing a deep dive, analysts from Goldman Sachs concluded that GE's insurance reserves appear "rational" when compared to peer comps.

August 27, 2019

• Fitch Ratings maintained GE's credit rating at BBB+ with a negative outlook. It is noteworthy that this is the same rating agency that earlier called GE one of the riskiest long-term care insurers.

September 3, 2019

• A Deutsche Bank analyst called the Markopolos report "plainly incorrect".

There is a lot more for [GE], than against the company.

So, what does all of this mean? Great question, and, in my opinion, it is up to you as a shareholder (or potential investor) to determine if the fraud claims are warranted or not. If you ask me, I believe that Mr. Markopolos is incorrect with his call that GE's accounting has been fraudulent and that the insurance reserves are insufficient. However, let me say this, Mr. Markopolos may have one thing right - i.e., GE's accounting has indeed been aggressive (and that is putting it lightly) for many years - but I do not believe that the type of fraud highlighted in the report was committed by GE's current or former management teams.

The Report Will Turn Out To Be A Net Positive... And The Turnaround Is Progressing

As a long-term shareholder that has suffered through the stock price decline over the last few years, I could have obviously gone without the Markopolos report, but I do believe that there is officially only one way for this company to go. Mr. Larry Culp and team currently have a short leash and there is no longer any wiggle room for brushing stuff off. Said another way, GE's accounting disclosures and management commentary will be critiqued in great detail, and this company will no longer be given any benefit of the doubt. And management knows this.

Therefore, at the end of the day, I believe that this is a positive development for investors that plan to keep money invested in GE. But as the old saying goes, only time will tell.

On September 4, 2019, Citi's Andrew Kaplowitz released an investor note saying that GE has already had meaningful progress in its turnaround. In addition, Mr. Kaplowitz maintained his "Buy" rating and said that he sees "significant long-term potential" for the stock. GE shares popped almost 6% on the back of this report.

The key comments from the Citi report, to me, are "meaningful progress" and "significant long-term potential". As I previously described, I believe that GE is heading in the right direction. GE is, however, not a one-to-two year turnaround story, but, instead, it will likely take at least three years for this story to play out. However, I do believe that the long-term potential is significant in that I see GE shares rising just as fast as they fell when management finally wins over the market. Remember, GE shares were up over 30% before the Markopolos report was released.

Risks

Upside Risk Factors - (1) Additional asset sales, (2) expanding margins, (3) improving cash flow metrics, (4) a quicker Power turnaround, and (5) "closure" for the Markopolos report.

Downside Risk Factors - (1) Concerns related to BioPharma deal, (2) margin pressure outside of the Power unit, (3) deteriorating cash flow metrics, (4) additional restructuring needs for the Power unit, (4) lower rates and the related Pension impact, and (5) the fraud charges sticking.

Bottom Line

It was smooth[ish] sailing before the Markopolos report, but, in my opinion, the fraud calls could turn out to be a blessing in disguise for long-term shareholders. There is no denying the fact that GE's accounting has been aggressive since Neutron Jack was running the show, so I believe that something big would have to happen to truly change the culture. Enter Markopolos and his colorful report.

The thought that GE's reports (investor presentations, quarterly and annual reports, etc.) can finally be trusted will, in my mind, go a long way toward improving investor sentiment. Whether Mr. Culp (and GE lifers) likes it or not, there is no longer an opportunity to hide the skeletons into the closet. GE and its management team were put on front street and there is no going back - the regulators, auditors, analysts, etc. are now officially watching their every move.

I still believe that Mr. Culp is the right guy for the job. He has the experience, and he has surrounded himself with a board that has what it takes to turnaround this once-great company. Moreover, I tend to agree with Citi in that the long-term potential for GE shares are significant, but, in my opinion, GE is definitely still a 3- to 5-year story.

Disclaimer: This article is not a recommendation to buy or sell any stock mentioned. These are only my personal opinions. Every investor must do his/her own due diligence before making any investment decision.

Disclosure: I am/we are long GE, BHGE. 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.