GE: Wait For $4, Then Buy
- GE is now struggling on all fronts as the pandemic batters GE Aviation, its primary profit driver.
- Outlook is bleak and recovery in Aviation along with Power and Renewables will be painful and slow over a period of at least several years.
- Yet, GE still has a portfolio of important businesses with upside potential.
- Turnaround is possible (and likely) and GE is still an investable company, but only at a lower valuation.
GE's (NYSE:GE) collapse has been well documented, but as of late, under new management, the company has been making strides to turn around the struggling conglomerate. However, these efforts have all been destroyed by COVID-19, sending shares to their lowest levels in the century.
With shares at such depressed levels, investors may view GE as a clear value opportunity given the sheer size and prominence of its businesses. However, the picture is not as clear. The COVID-19 pandemic has battered its most valuable and profitable business segment, Aviation, and much of its remaining businesses are losing money. GE Healthcare, though benefiting from a surge in pandemic-related products, has been hit in other areas as hospital priorities shift away from elective procedures. The result of these factors is a seriously troubled business that is burning through cash with little recovery prospects in the short-term. Although a turnaround is definitely possible - in fact I believe GE has the right team in place that is taking the right steps towards righting the ship - it will be much slower than previously expected and more painful for shareholders. Thus, investors should wait for a lower valuation before investing in GE.
Core Issues Linger, But GE Was On The Right Track
Even before COVID-19, GE was plagued with a laundry list of problems driven by years of mismanagement. Nowhere else was this more clear than at GE Power where plunging power prices and a disastrous $14 billion acquisition destroyed a once storied business that today has a negative profit margin of 3.2%. The fall of GE Power, once GE's largest business segment, has been swift and is a symbol of years of mismanagement.
New CEO Larry Culp was tasked with reversing years of problems, and since taking over in 2018, he has taken decisive action to modernize and revamp GE. In his short tenure thus far, Culp has aggressively worked to pay down debt, winding down its stake in Baker Hughes and selling assets like its legacy consumer light bulb division for $250 million and Biopharma business to Danaher (DHR) for $21.4 billion. Through these efforts, GE's debt load has been reduced from over $100 billion in 2018 to around $85 billion today. To turnaround GE's struggling businesses, Culp has made significant management changes, reducing GE's large bureaucracy towards a more lean management style that increases accountability. This includes splitting GE Power into two focused divisions, bringing in new CFO Carolina Dybeck Happe, and cutting employee headcount drastically, from over 283,000 to just over 200,000 today.
COVID-19 Has Grounded GE's Turnaround
Clearly, the COVID-19 pandemic has been a major disruption for all businesses. But for GE in particular, it has ground the company's turnaround efforts to a halt and exacerbated the lingering problems that the new management has been working feverishly to correct.
The most obvious disruption for GE is in Aviation, a division that before the pandemic was its most profitable business bringing in $4.4 billion in free cash flow and one of its few bright spots. But as global travel plummeted and demand for aircraft by corollary evaporated overnight, it is no longer a bright spot and the outlook for this segment has suddenly become bleak. In an industry where demand for aircraft has been insatiable, this sudden shift is a shock and likely the start of a multi-year downturn. Although the segment still has a $273.2 billion backlog, this is now in question. Short-term demand has plummeted, and in response, GE is massively scaling down production and cutting 10% of its US workforce. Adding to the worry is GE's exposure to Boeing's (BA) issues with the 737 MAX whose recertification timeline has been repeatedly pushed back and now estimated to occur in August. GE produces the CFM LEAP engines through a 50-50 joint venture with Safran (OTCPK:SAFRY), the exclusive engines on the 737 MAX, and the company recorded orders for just six new engines in Q1 2020 compared to 636 new engine orders in Q1 2019. Compounding the problem, 299 737 MAX orders have already been cancelled by airlines struggling to survive and hundreds more are likely in jeopardy as global air travel continues at just a fraction of their past levels.
Some have speculated that the end to new aircraft purchases could perhaps lead to more aftermarket service revenue due to airlines using older aircraft in their fleets. However, this is simply not the case and any additional maintenance work will be vastly overshadowed by the lost revenue coming from parked planes (most airlines are operating at less than 20% capacity). Less service work will continue into the typically summer travel season as well, which is why GE has furloughed 50% of its maintenance workers for three months. The loss in service revenue is another major blow because maintenance and engine services are where GE makes the majority of its profits in Aviation (and company-wide) and it was a predictable source of income free from cyclical pressures in other divisions. Moving forward, GE will lose this major cash generator and difficulties in Aviation will be a major burden on its entire financial outlook.
The downturn in Aviation extends beyond engines into its aircraft leasing entity GECAS. GECAS, another highly profitable business before the pandemic, has seen its fortunes sour quickly and to date 85% of customers have asked it for short-term deferrals. This puts it in a precarious situation that will likely force GECAS to strike a deal to lower rates because it can't push too hard (and risk an airline bankruptcy) given the macro environment and the glut of aircraft in the market. It could pursue alternative strategies such as repossessing aircraft, something Culp said GECAS was preparing to increase, but this poses additional problems considering there is really nowhere to place the repossessed aircraft other than in storage. No matter the option chosen, GECAS is in major trouble and investors should prepare for a large write-down in the coming quarters.
Healthcare is the one area that should and has been benefiting from the pandemic. In Q1, organic sales and profit increased by 9% and 10% respectively as sales of COVID-19-related products like CT scanners and x-ray machines soared. This was also helped by several deals GE struck with the government, including a $336 million deal partnering with Ford (F), to directly make thousands of ventilators. Healthy sales growth in Healthcare is a silver lining for investors in a company that is struggling on all other fronts. But even in this bright spot, not all is well. As hospitals continue to prepare and leave space open for COVID-19 patients and people stay home afraid of entering hospitals, the amount of elective procedures have plummeted. Elective procedures are typically more profitable for hospitals and stopping them, whether through mandates or by choice, is why some hospitals have actually gone bankrupt and closed their doors during the pandemic. For GE, this means its larger and more expensive equipment, such as MRI machines and products like tracers in its Diagnostics segment, have actually seen sales decline.
Turnaround Prospects Greatly Delayed
Valuation Too High
Right now, GE is not hitting on any of its cylinders. Even before the pandemic hit, GE was in a difficult place with three of its five segments (Power, Renewable Energy, and Capital) projected to lose money in 2020. Culp's work to turnaround these divisions was expected to take years and only begin to bear fruit in late 2021 because time was needed to work through an unprofitable backlog at GE Power among other challenges. Today though, all of these efforts are delayed and the most obvious casualty is its balance sheet. Following a period of aggressive selling of non-core assets to raise money, Culp hoped to bring leverage down from over 4x net debt to EBITDA to under 2.5x by the end of 2020 while contributing $4-5 billion to the troubled pension plan. But with its largest profit driver (aviation) deteriorating quickly and other divisions struggling as well, GE now expects a negative free cash flow of $3.5-4.5 billion in Q2 (much worse than the negative $2.2 billion in Q1), a shock that wipes out a good chunk of the progress that had been made and a signal of the tough road forward. Debt will creep upwards once again, but this time, GE will not be able to quickly raise tens of billions of dollars through asset sales. A heavy debt burden will make the eventual turnaround much more difficult and give Culp and the management team even less room for error.
GE's problems are obvious, which is why the stock is down nearly 50% in 2020 and at a price lower than even in 2008. From a valuation standpoint though, the company in a traditional sense is still not cheap. Using projected earnings of $0.11 this year (which may even be too generous), forward PE is around 60x. This is significantly higher than many of its rivals such as Honeywell (HON), 3M (MMM), and Siemens (OTCPK:SIEGY), all of which have a forward PE of around 20.
Obviously using forward PE is a skewed metric for judging a company that has a turnaround opportunity. But for GE, a turnaround will be harder than ever, and many of the difficult conditions it is going through right now will persist. In GE Power, with energy consumption falling, usage of GE's gas turbines have decreased by 10%. Combine that with social distancing rules in place, many companies have cut back and deferred maintenance and other services. For example, Dominion Energy (D), which owns upwards of 15 GE turbines, has decided to defer 75% of maintenance work. The slowdown in the energy industry along with supply chain delays has also resulted in fewer orders. GE Power in Q1 booked just 22 new orders compared to 35 in the Q1 2019. In its Renewable Energy business, organic revenue did increase by 28% and its onshore wind business is positioning itself to become a sustainable area of strong growth. However, the area still is unprofitable with negative margins (-9.5%), something that is not expected to change anytime soon.
In Aviation, although the air travel market has likely already bottomed out, it will take years to return to the high growth environment the industry was in just months ago and for the division to once again post the $32.9 billion it delivered in revenue in 2019. Passengers are flying again, but this does not directly translate into more orders for aerospace companies because airlines are still struggling even with billions in government aid. The result will be a slow recovery with aircraft purchases stalling for the foreseeable future, which is why both Boeing and Airbus (OTCPK:EADSF) have cut down on their production rates including for 787s, 777s, and A320neos. This is painful for GE and especially for its highly anticipated GE9X engine, which was prepared to enter service with a splash on the Boeing 777X. But now with Boeing cutting 777 production from five to three per month and many airlines shying away from ordering the 777X in favor of smaller jets, the demand and commercial opportunity for this engine is now much lower. The silver lining is that the military business in GE Aviation is still strong as defense budgets increase and military flights continue despite the pandemic. Important to note though is that this business is much smaller (just $4.4 billion in revenue in 2019) and competition is fierce. The level of competition was put on display when the Air Force revoked GE's sole-source contract for 480 F-15EX fighter engines (due to Pratt & Whitney's objection) and opened it up for bids. It seems as if GE cannot catch a break in any part of its business.
To this point, I have barely touched on GE's other liabilities of which there are plenty. The pension, at less than 80% funded, is a lingering issue that is made worse given the near zero interest rate environment that we are in today. GE committed to adding $4-5 billion in 2020 but that number may be forced to increase as the funding gap increases. GE's long-term-care insurance problems persist as well and the company still has over a quarter of a million LTC policies on its books. On top of all this, GE is fighting a $1 billion tax lawsuit in Britain. In order for a turnaround to be successful, GE not only must turn around nearly every single business division, but it also must address these side issues as well. That will be a very challenging task moving forward.
Liquidity Still Strong
GE has problems, but bankruptcy is not likely. The company has strong liquidity with $47.3 billion in cash at hand and another $35.3 billion available through credit facilities. Though debt at $85.2 billion seems high, this has been reduced significantly, and as the following figure shows, the maturity schedule is spread out with no major payment due until 2022. From a liquidity standpoint, GE is strong. Moreover, the company has taken quick action to immediately conserve $3 billion in cash by reducing headcount and cutting spending.
Source: GE Q1 2020 Presentation
Buy GE…At the Right Price
This article has outlined the many problems that GE is facing and shows that 2020 will be another lost year for GE. But writing this, I still believe that GE will be able to turn around the business and that, in Culp's own words, COVID-19 has caused "a delay" in the turnaround "rather than a redirection." Rather than resorting to splitting up the business, GE has the potential to fix its problems and continue as a conglomerate whose different businesses create value together. Culp successfully accomplished this at Danaher and is making progress through a leaner management style with more accountability and focus. He put this on display in a recent conference to show how the new structure was actually being implemented.
Source: GE Presentation at Bernstein Conference
Management changes are intangible factors, but nonetheless important ones because at the core, struggling businesses like GE Power are still vital and bring valuable technology that is demanded in the world. They can be profitable under the right leadership, which I believe is in place, that makes adjustments to strive towards profits, not just more market share. The road to accomplish this is long, but ultimately, there is light at the end of the tunnel.
I believe in the turnaround, but the current valuation is simply too high for a low-growth company that contains enormous risk and is unprofitable in nearly all segments of its business. A more attractive valuation is somewhere in the $4-5 range (market cap under $44 billion), giving GE a forward PE of under 45 for 2020 and around 15 for 2021. This valuation in my view properly takes into account the issues in Aviation that will stretch at least several years beyond 2020 and the delayed timetable for returning GE Power and Renewable Energy to profitability.
Despite Culp's swift actions to focus GE and pay down debt, the company was still struggling. But once the pandemic hit, COVID-19 exacerbated GE's lingering problems and created new ones, battering the already struggling GE Power while turning one of its only bright spots, Aviation, from a shining star into a years-long recovery project. These problems are why the stock's collapse is well warranted. Nevertheless, I believe a turnaround will still be possible. But in order to account for the serious risk that persists, investors should hold right now and wait to buy at a price of around $4-5 per share.
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