- General Electric was a bad investment over the last couple of years, and ran into operational problems through 2019.
- In 2020, things got even worse, due to the impact the coronavirus pandemic has on GE's businesses.
- Shares have lagged both the broad market and its peers, and rightfully so.
- If management can successfully turn this ship around, shares could recover a lot of ground. But we believe that it is more prudent to go with higher-quality choices in the industry instead.
- This idea was discussed in more depth with members of my private investing community, Cash Flow Kingdom. Get started today »
General Electric (NYSE:GE), which has had more than its fair share of problems during the last couple of years, has run into a range of additional problems caused by the coronavirus pandemic. This includes, but is not limited to, headwinds for its aircraft engine business, which normally is the company's crown jewel.
Shares are not trading at an expensive valuation relative to the revenues that the company generates, but due to General Electric's myriad of problems, going with other industrial names may be the better choice for investors.
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Core Peer Siemens Was The Better Choice
A couple of months ago, we wrote an article detailing why we believed that Siemens (OTCPK:SIEGY) (OTCPK:SMAWF) was a better pick compared to General Electric. This article was centered around factors such as a stronger balance sheet for Siemens, a more attractive product lineup with more exposure towards higher-growth markets such as Industry 4.0, and a more efficient way of operating the company. Since then, the performance of Siemens and General Electric has been quite different:
Since then, Siemens' shares are down 13%, virtually on par with the Dow Jones Index (DJI) (DIA), while General Electric has generated a total return of -43% in the same time frame. This was not based on a weaker performance during the midst of the market sell-off, where Siemens and GE had dropped more or less the same. Instead, the market's cognition that Siemens was much better positioned to weather the current crisis has allowed Siemens' shares to recover most of the losses during April and May.
Siemens is not the only peer we can compare General Electric to, the following chart could be quite illustrative, especially regarding items such as ROIC or interest coverage:
Note: Margin of Safety = the difference between fair value using discounted cash flow analysis and price.
Yacktman Forward RoR is the normalized average free cash flow of the past seven years plus the expected 5-year growth rate.
General Electric's Issues Are Getting Worse
This brings up the question of why General Electric's share price has not recovered, as the market seemingly is not seeing an easy recovery for General Electric.
This is due to a range of reasons, the first one of these is that General Electric is lacking the backlog that Siemens has. In fact, Siemens was even able to grow its industrial backlog further during the first quarter of 2020, despite the emerging pandemic. A large backlog allows Siemens to keep its factories running during times when new orders are at a below-average level, which will undoubtedly be the case for Q2, and likely for the remainder of 2020 as well. Siemens can keep producing and selling its products to customers that have ordered in the past, while General Electric's smaller order backlog prevents the company from keeping utilization high. Lower utilization of General Electric's factories, in turn, means that revenues will drop. Even worse, margins will compress further, as fixed costs remain in place while gross profits will decline.
For a company that already has below-average margins relative to its peer Siemens, and also relative to other industrial heavyweights such as Honeywell (HON) and 3M (MMM), the outlook of further margin compression is disastrous.
The lacking backlog to combat a period of lower orders, which will lead to lower profitability, is only one factor, though. On top of that, General Electric's jewel, its aircraft engine business, is facing the steepest headwinds in its history. The current pandemic poses the biggest threat to global airlines that has ever existed, which forces many airlines to cancel orders for new aircraft in order to preserve cash to battle the current crisis. This results in lower aircraft production rates from the two industry leaders Boeing (BA) and Airbus (OTCPK:EADSY). Those two commercial jet producers buy most of their engines from General Electric and from Rolls-Royce (OTCPK:RYCEY), but as they are reducing their output, purchase volumes decline as well.
This means that General Electric's aircraft engine business, which has reported strong growth rates in the past, will likely see meaningful pressures in the near and medium term. Analysts had valued the unit at anywhere between $50 billion and $100 billion in the past. With the large and multi-year negative impact of the coronavirus crisis on global air travel, it could be argued that the value of the unit has dropped by dozens of billions of dollars.
Over the last three months, the market capitalizations of Airbus and Boeing have dropped by around 45%. As a core supplier to these two companies, one could assume that the value of General Electric's aircraft engine business may have also lost a similar share of its value. Using the original estimate for the unit's value, this equates to value destruction of $22.5 billion-45 billion over the last couple of months, for just one of General Electric's units. This may not be the ultimately correct amount of lost value, as the market could be valuing Boeing and Airbus too conservatively right now. But based on the massive impact that the current crisis has on global airlines, it does not seem unreasonable to assume that General Electric's crown jewel has easily lost $10+ billion of value.
The unit has recently slashed 25% of its workforce, which would surely not be a necessary move if General Electric's management believed that the unit would recover to pre-crisis levels in the near term. The following statement by the unit's CEO David Joyce is quite telling: "The deep contraction of commercial aviation is unprecedented ... Unfortunately, more [cost-cutting] is required as we scale the business to [reality]."
General Electric's problems don't end there, however, as the company also continues to face issues with its balance sheet. The sale of its biotechnology business to Danaher (DHR) provided the company with some cash that could be used to reduce debt, but on the other hand this sale further weakened General Electric's ability to generate profits and cash flows. The cash flow outlook for 2020 is looking quite worrisome, as management is forecasting a $4 billion free cash flow shortfall for the current quarter alone. For a company like General Electric, which has already had quite weak cash generation power before the current crisis, and that has a highly levered balance sheet on top of that, this is quite a problem.
General Electric has total net long-term liabilities of $65 billion right now, while it generated less than 5% of that, or just $2.7 billion, in free cash flows over the last year. With a Q2 cash shortfall of $4 billion, General Electric's free cash flow during the current year will easily be negative, even when we assume that Q3 and Q4 will see no impact from the coronavirus pandemic, which seems highly unlikely.
To sum up, we can say that General Electric's pre-existing problems, such as weak margins, low backlog, weak cash generation, etc. all will get worse during the current crisis. On top of that, its best business by far, the aircraft engine unit, is facing the biggest headwind in its existence. The fact that General Electric's shares have not participated in the broad market recovery over the last two months is thus easily explained by the market's realistic views about General Electric's future.
So, What To Invest In?
Industrial companies are not a bad investment per se, and those that seek exposure to all large industries may still want a stock from that space. Siemens is a viable alternative, we believe, but among other large-cap industrial corporations, there is a range of candidates as well:
Based on a fundamental screen that accounts for indebtedness (debt to EBITDA) and profitability (gross margins), Honeywell, 3M, and Illinois Tool Works (ITW) all look like more attractive investments compared to General Electric.
Based on the dividend yields that investors receive from their investments, and based on cash flow multiples investors have to pay, all three of these companies, once again, look more impressive than General Electric. This is not a deep dive into General Electric's peers, but we believe it is opportune for investors to take a look into these higher-quality companies rather than buying General Electric's shares right here.
General Electric once was a beloved company, and it still is a household name. Unfortunately, mismanagement and disastrous capital allocation decisions have hurt the company a lot. During the current pandemic-caused crisis, additional problems were created, primarily for General Electric's aircraft engine business. This is not management's fault, but it nevertheless hurts investors and the company's prospects.
Siemens was a better investment compared to General Electric in the past, and we believe that this could still be true. Other industrial machinery companies such as Honeywell or 3M look more attractive, too.
It should be noted that General Electric's management is trying to turn the ship around, and based on a price to sales multiple of just 0.6, General Electric's shares do not look expensive. But until management has achieved higher levels of profitability and cash flows, all those revenues do unfortunately not have any value for shareholders.
We believe that General Electric's shares should be avoided, as peers provide better business models, stronger fundamentals, and more potential for sleep-well-at-night-investing. Short-term oriented traders or those gambling on a successful turnaround may want to choose General Electric, but we do not see this as an overly attractive proposal right here.
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This article was written by
Jonathan Weber holds an engineering degree and has been active in the stock market and as a freelance analyst for many years. He has been sharing his research on Seeking Alpha since 2014. Jonathan’s primary focus is on value and income stocks but he covers growth occasionally.He is a contributing author for the investing group Learn more.
Analyst’s 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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