Buy GE Now Before The Share Price Returns To Pre Markopolos Levels
The best response by GE to Markopolos' research report would be to remove or reduce any grounds for criticism. Two key issues are levels of indebtedness, and the accounting treatment of losses associated with GE's investment in BHGE. I make a case below that these will no longer be issues by end of Q4 2019, and possibly as early as end of Q3 2019. When these two issues are resolved, I expect GE share price to move back to levels pre the Markopolos report, or higher. Markopolos' report has provided an opportunity to buy GE shares now, at a lower entry price than would otherwise be the case. The chart below of GE share price movements pre and post the Markopolos report should provide encouragement to momentum buyers. Expect momentum to build on the news of close of the BioPharma sale.
Source: The GE Brief
Thesis For GE's $38 Billion Debt Reduction In FY 2019
GE Industrial: Net Debt At June 30, 2019 - $54.4 Billion
GE's 2nd quarter 10-Q at page 21 shows -
FINANCIAL POLICY. We intend to maintain a disciplined financial policy, targeting a sustainable credit rating in the Single-A range with a GE industrial net debt*/EBITDA ratio of less than 2.5x and a dividend in line with our peers over time, as well as a less than 4-to-1 debt-to-equity ratio for GE Capital. We remain on track to deliver against these leverage goals. GE industrial net debt* was $54.4 billion and $55.3 billion at June 30, 2019 and December 31, 2018, respectively.
GE Industrial: Sources Of Actual And Potential Cash Proceeds From Asset Sales
- General Electric (GE) can expect net cash proceeds of $20 billion from its BioPharma business sale to Danaher, scheduled to close in Q4 2019.
- GE can expect to receive $12.3 billion in cash from sale of its remaining 50.4% interest in Baker Hughes, a GE company (BHGE), based on share price of $23.52 at September 5, 2019. TABLE 1 below shows the details -
- GE sold almost all of its remaining interest in Wabtec Corporation (WAB) in 3rd quarter (August 9, 2019) for net proceeds of $1.44 billion (see here).
- Once GE reduces its interest in BHGE below 50% it will de-consolidate its interest in BHGE, and report its remaining interest at market value based on current share price. GE could sell all of its shares or just less than 1.0% of its shares and the de-consolidation would still take place. The de-consolidation will result in GE reducing its reported GE industrial net debt by ~$4 billion for the BHGE component currently being consolidated (see my article, "GE: Understanding The Baker Hughes Transaction" for a comprehensive explanation of the consolidation process).
GE Industrial: $38 Billion Debt Reduction Summary
The impact of all of the foregoing is summarized in TABLE 2 below.
TABLE 2 shows GE is well positioned to reduce its industrial net debt/EBITDA ratio to 2.4x, slightly below the target of 2.5x (see above). The estimated non-GAAP EBITDA figures of $7.0 billion in Case A and $7.4 billion in Case B are calculated by annualizing the first half reported EBITDA figure of $4.27 billion (see below), and deducting an estimate of Biopharma ($1.2 billion) and BHGE ($0.4 billion) EBITDA due to their disposition.
GE 2Q'19 Supplemental Information at page 2 shows GE's calculation of adjusted non-GAAP EBITDA for first half 2019 -
That completes my thesis on GE's debt reduction outlook. The next matters to discuss are the compelling reasons why GE and Danaher might wish to accelerate the completion of the BioPharma business sale, to achieve a close in Q3 2019.
GE's and Danaher's Announcements Of The Biopharma Sale
General Electric Press Release Dated February 25, 2019 -
BOSTON – February 25, 2019 - GE (NYSE:GE) announced a definitive agreement to sell its BioPharma business to Danaher Corporation (NYSE: DHR) (“Danaher”) for a total consideration of $21.4 billion, including $21 billion in cash as well as Danaher’s assumption of certain pension liabilities. GE expects to use the proceeds from the transaction to reduce leverage and strengthen its balance sheet. The transaction is expected to close in the fourth quarter of 2019, subject to regulatory approvals and customary closing conditions.
Danaher Corporation Press Release Dated February 25, 2019 -
DANAHER TO ACQUIRE THE BIOPHARMA BUSINESS OF GENERAL ELECTRIC LIFE SCIENCES FOR $21.4 BILLION
Washington, D.C., February 25, 2019 – Danaher Corporation (NYSE: DHR) (“Danaher” or the “Company”) announced today that it has entered into a definitive agreement with General Electric Company (“GE”) (NYSE: GE) to acquire the Biopharma business of GE Life Sciences (“GE Biopharma”) for a cash purchase price of approximately $21.4 billion. Given anticipated tax benefits from the transaction structure, the net purchase price is approximately $20 billion. This represents a multiple of approximately 17 times expected 2019 EBITDA for GE Biopharma....GE Biopharma is expected to generate annual revenue of approximately $3.2 billion in 2019, with approximately 75% of these revenues considered recurring....Danaher expects to finance the all-cash transaction with approximately $3 billion of proceeds from an equity offering (which may include an offering of mandatory convertible preferred shares), and the remainder from available cash on hand and proceeds from the issuance of debt and/or new credit facilities....Danaher estimates the acquisition will reduce GAAP diluted net earnings per share by approximately $1.15 to $1.20 but will be accretive to non-GAAP, adjusted diluted net earnings per share by approximately $0.45 to $0.50 in the first full year post acquisition. The non-GAAP, adjusted diluted net earnings per share amounts exclude anticipated non-cash amortization, purchase accounting charges and transaction expenses attributable to the acquisition, as well as stand-up costs related to carving out the business. The dilution impact from the anticipated equity financing for the transaction is included in both of these GAAP and non-GAAP diluted earnings per share figures...The transaction is expected to be completed in the fourth quarter of calendar year 2019, and is subject to customary conditions, including receipt of applicable regulatory approvals.
Note: bolding is by author.
Why I Expect An Accelerated Close Of The GE and Danaher BioPharma Transaction Is Likely
An Early Close From A Danaher Perspective -
In its 2nd quarter 10-Q p.50, Danaher stated,
We expect to incur up to approximately $18 billion of additional indebtedness to fund a portion of the purchase price of the GE Biopharma Acquisition.
The balance purchase price of $3 billion has already been raised through equity offerings. Together with strong operating cash flows, this has increased Danaher's cash by $4.6 billion to an ending balance of $5.4 billion in the six months ended June 30, 2019. The additional equity has increased estimated weighted average diluted share count for FY 2019 from ~711MM to ~737MM causing some dilution of EPS.
In an SEC filing dated August 29, 2019, Danaher announced increase to $5 billion for an existing unused borrowing facility, and a new borrowing facility of $5 billion towards the $18 billion target. In an SEC filing on September 3, 2019, Danaher filed a registration statement for a prospectus for senior notes totalling €6.25 billion (~US$6.8 billion), with a settlement date of September 18, 2019. TABLE 3 below shows by September 18, 2019, Danaher will have the cash available to settle the Biopharma business purchase, with ample liquidity remaining.
Advantage to Danaher From Closing In 3rd Quarter -
Danaher has already issued additional shares for the equity component of the required funding, causing some dilution of earnings per share. Once the purchase of the GE BioPharma business is completed, non-GAAP EPS is expected to increase by $0.45 to $0.50 per year, as referenced above. Completion by end of 3rd quarter, rather than end of 4th quarter, will potentially increase 4th quarter and full year 2019 non-GAAP EPS by $0.11 to $0.12 (~$80MM to $90MM non-GAAP net income). Closing in the 3rd quarter, and including Biopharma business earnings in 4th quarter will substantially offset the dilutive effect of share issues in FY 2019, per TABLE 4 below. Danaher will be able to lift guidance for both Q4 2019 and for FY 2019.
An Early Close From A GE Perspective -
- A 3rd Quarter Close Would Eliminate Concerns The BioPharma Deal Might Not Close -
SA News report May 16, 2019 -
General Electric's (GE -1.6%) deal to sell its Biopharma unit to Danaher (DHR+1.1%) could be in jeopardy, says Gordon Haskett analyst John Inch, after some competitors posted weaker than expected quarterly results.
The possibility the deal might not close has to be a valid concern, even if considered a remote possibility. Closing in the 3rd quarter would put that concern to rest.
- A 3rd Quarter Close Would Not Materially Impact GE's Adjusted Non-GAAP EPS
As calculated above the Biopharma business is expected to increase Danaher's Q4 and FY 2019 adjusted Non-GAAP net income by $80MM to $90MM. A reduction by a similar amount for GE would have an impact of less than $0.01 per share, due to GE's much larger share count.
- A 3rd Quarter Close Of The Biopharma Sale Would Greatly Reduce Concerns At The Level Of GE Debt
GE is constantly under attack by its detractors over its debt levels. The sooner the $20 billion from the Biopharma sale becomes available to reduce net debt, the sooner these attacks can be demonstrated to be unfounded.
- A 3rd Quarter Close Of The Biopharma Sale Would Cause Earlier Recognition of ~$14 Billion Gain On Sale
A close of the Biopharma sale in Q3 2019 will crystallize a gain on sale of ~$14 billion before tax, as detailed in my article, "General Electric's $14 Billion Profit On BioPharma Sale"
A 3rd Quarter Close Of The Biopharma Sale Would Facilitate Formal Recognition Of The Loss Of ~$7.5 Billion On GE's Interest In BHGE
- Timing Is Everything -
As I explained in my article, "General Electric's $14 Billion Profit On BioPharma Sale", I fully expect a smart operator like GE CEO, Larry Culp, to time the recognition of the loss on GE's interest in BHGE with the recognition of the gain on the sale of the BioPharma business. That way the company reports a significant profit for the particular quarter, rather than having a significant reported loss in one quarter and a significant reported gain in another quarter. Larry Culp will do his best to avoid GE reporting a quarterly loss on his watch. In my article above, I put forward GE would not allow its interest in BHGE to go below 50%, until the quarter in which the BioPharma sale gain is recognized.
- The Pressure Is Building, On Two Fronts, And Time Is Running Out -
GE may be technically correct in continuing to consolidate BHGE results rather than using "mark to market" for its investment in BHGE. But this type of approach has made GE an easy target for Markopolos in his research report. Given what has transpired over the past few years, GE do not need to unnecessarily leave themselves open to charges of "tricky" accounting, and lack of transparency. Also, there is a doctrine of consistency in accounting, so GE cannot just change the basis of their accounting for BHGE in say Q3, 2019 without restating prior quarters and prior years. Imagine the stir that would cause - it is not an option. The easy way out would be to sell a small parcel of BHGE shares in Q3 2019, to take their interest in BHGE below 50%. The accounting standards would then allow GE to mark to market their investment in BHGE, without any requirement to restate prior periods. The problem with that is, GE must then officially report a Q3 2019 loss on investment in BHGE of ~$7.5 billion. As mentioned above, I believe Culp will not want any future quarter's results to show a loss on his watch. In the event the Biopharma close cannot be achieved in Q3, Culp could avoid mark to market of the BHGE investment by delaying a reduction in BHGE below 50% to Q4 2019, when a loss on BHGE shares would be more than offset by a gain on the Biopharma sale. Unfortunately, that will likely not avoid GE being forced to recognize a loss on its BHGE investment in Q3 2019. Pressure to recognize a loss on GE's investment in BHGE is building on another front, as explained below.
- SEC Has Raised Concerns About The Need For Recognition Of An Impairment Charge For The Oil & Gas Segment -
If Culp does not want a quarterly loss recorded on his watch, another asset impairment charge, forced on a reluctant GE by the SEC, would have to be his worst nightmare. And a public and investor relations disaster to boot. But that is what is looming in Q3 2019, unless GE takes the easy way out and reduces its interest in BHGE below 50% in the quarter. This means it is imperative for Culp to accelerate the close of the Biopharma deal to Q3 2019, to avoid reporting a loss for the quarter. Here are the details of the issue raised by the SEC. SEC issued to GE a letter dated June 27, 2019 referring to a review of the company's FY 2018 10-K and Q1 2019 10-Q filings as per excerpt below -
We note that your qualitative review of reporting units in the BHGE segment did not identify any reporting units that required an interim impairment test. However, your disclosure here and in Note 15 on page 60 discusses sustained declines in BHGE’s share price, which remains below your current carrying value. Please tell us how you considered the factors outlined in ASC 350-20-35-3 in determining that no further impairment testing was necessary.
GE provided a response by letter dated July 11, 2019. An excerpt from that letter appears below -
.... the Company performs its goodwill recoverability assessment based on an individual reporting unit being sold to a market participant on a controlling basis (i.e., inclusive of a control premium). This measurement differs from the loss of $7,300 million disclosed in Footnote 15. The loss disclosed in this footnote represents the loss the Company would have recognized upon deconsolidation of BHGE as of April 26, 2019 and is measured on a noncontrolling basis in accordance with ASC 810-10.
The Key Impairment Testing Assumption Does Not Stand Up To Scrutiny -
The assumption, "...the Company performs its goodwill recoverability assessment based on an individual reporting unit being sold to a market participant on a controlling basis (i.e., inclusive of a control premium)", appears to be in conflict with the BHGE Stockholders Agreement terms (see here page 151)
After the expiration of the two-year lockup period, GE and its affiliates will generally be permitted to transfer their shares of Common Stock; provided, they will be prohibited from transferring (without the prior consent of the Conflicts Committee) any shares of Common Stock to any person that is not an affiliate of GE or to any “group” (as such term is used in Section 13(D) of the Exchange Act) if such person or group would beneficially own more than 15% of the voting power of the outstanding shares of Common Stock after such transfer.
Apart from the fact GE is not allowed to sell a controlling interest in BHGE, it also does not appear to have any plan to attempt to realize a control premium. An impairment test based on including a control premium in the valuation of GE's investment in BHGE appears to lack validity. On top of that, per Figure 2 below, the BHGE share price has further decreased since the SEC raised its concerns about Q1 2019 impairment testing.
Where Are The Directors?
It is concerning that GE do not appear to have dealt appropriately with impairment testing of the BHGE asset. The CFO is departing and I would hope there is more rigor from the new appointee. I am reminded of the article I wrote when John Flannery departed at the time of the 2018 $23 billion Power impairment charge, "How A Simple Valuation Exercise Brought Down The CEO Of A Fortune 500 Company". The CFO's departure was announced on July 31, soon after the company's July 11 response to the SEC's questioning on impairment of the BHGE asset. Did a simple valuation exercise also bring down the CFO of a Fortune 500 company? In this 2018 article I expressed a belief the appointment of new directors would lead to an improvement in the presentation and transparency of GE's financial statements. So far, I have to say my expectations have not been met. Maybe the search for a new CFO is a step in that direction.
Logistics Of Closing The Biopharma Sale By September 30, 2019
From a logistics point of view, I do not believe there is anything disadvantageous in closing the sale on September 30, versus a close on year end December 31. There might be some advantage for Bristol Myer (BMY) and Celgene (CELG) to complete the merger on a year end date of December 31, to avoid separate accounting and audit effort for a part year or stub period, instead of relying on the work involved in preparing the audited annual financial statements. But for GE and Danaher, there could be a distinct advantage in closing at September 30, to take the additional work involved away from the busy financial year end period. There were a whole raft of SEC filings required leading up to the spin-off of GE's Transportation business to Wabtec (WAB). But this was due to it being a spin-off, whereas the Biopharma business disposition is a straight out sale. In Q2 2019 10-Q, under Note 2: Businesses Held For Sale And Discontinued Operations, GE disclosed -
In the first half of 2019, we closed certain of these transactions within Corporate and our Power and Aviation segments for total net proceeds of $1,049 million,...These transactions are subject to customary working capital and other post-close adjustments. As of June 30, 2019, we have closed the sale of substantially all of these assets in accordance with the plan.
Apart from it being a much larger transaction, I expect the closing of the Biopharma sale will follow a similar path to that described for the $1,049 million net sales in the first half. Provided all due diligence has been completed, the close could be just awaiting Danaher receiving the cash from the Senior Notes due to be settled on September 18. With the whole of the $21 billion required cash scheduled to be available by September 18, there is ample time to close the transaction on or before September 30, with the transaction "subject to customary working capital and other post-close adjustments". Danaher has made two announcements in quick succession revealing total new borrowings of ~$12 billion, with most of the funds available now and the balance by 18 September. I see no reason why Danaher would raise those funds now and then sit on the funds into Q4 2019, if an earlier close were possible.
Summary and Conclusions
It is in the interests of both GE and Danaher to do everything possible to bring the closing of the Biopharma transaction forward into Q3 2019. Danaher will have the cash available to settle and a close by September 30 appears eminently feasible.
The BHGE valuation matter can most expeditiously be dealt with by sale of a relatively small number of BHGE shares between now and end of September. The likely alternative is an impairment charge. Either way will mean recognizing a significant loss in the reported results. This is more reason for GE to speed up the BioPharma transaction to book the profit in Q3 2019, as an offset to a reported loss or impairment related to the BHGE asset.
I might be critical of GE's financial reporting, but I believe GE has an enormous pool of human talent and valuable intellectual property. And I remain confident Larry Culp is the person to harness this talent and intellectual property to create a very profitable enterprise.
Markopolos' report has caused a significant reduction in the share price. That provides an unexpected opportunity to buy GE shares now, at a lower entry price than would otherwise be the case.
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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.
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