A Bear On GE Reassesses

Background

I began to write bearish articles on General Electric (GE) this year, comparing it after Q1 earnings to another venerated Dow 30 stock (DIA) in GE: Another IBM. GE was around $ 30 then. After Q2 results were reported in July, with GE in the $ 25-26 range, I wrote my third and most recent GE article, A Bear On GE Outlines Reasons To Avoid This Name. Both these articles pointed out that using valid GAAP accounting, GE was overpriced, and made other points showing several operational issues at GE that made the stock appear overpriced.

Now that GE has closed Friday at $ 23.83, providing substantial negative alpha relative to the DIA and the S&P 500 (SPY) at large since my articles, I’ve had a day or two to think about this economically important, iconic name and would like to offer up some concise observations about Q3, the new senior management team, and how the stock may trade in the months ahead.

First, putting GE stock in perspective may be valuable.

GE – a brief historical perspective

At its current price, GE is trading at the same price as 20 years ago. Going back to the dawn of its great bull move, it was approximately a split-adjusted $ 1 stock in 1981. At its peak of $ 60 in Y2K, the stock price had risen at a 24% CAGR, with dividends extra. However, 17 years after Y2K, the CAGR has dropped to 9.1%. GE cut its dividend in the Great Recession. If we assume a 3.4% dividend yield since 1981, which is just a guess, the annualized total return would appear to be about 12.5%. That may look good at today’s interest rates, but in 1981 and for at least the next 13 years, that was at first worse than bonds provided and eventually just OK.

Operationally, GE is returning to its Edison-era roots. If GE were to break into three or four companies, I would view it as largely a power/energy/lighting company, with health care as a separate company, and aviation/transportation as the other separate company or companies. Both health care and aviation look healthy to me.

That GE has mostly ditched its financial services arm is a positive. The pain from that business segment is not over, but the company is pledging that basically it will be a financing company only to advance its basic businesses; i.e., it will engage in vendor financing but will be exiting or winding down such difficult and now extraneous business lines as long term care insurance.

The announcement in the webcast presentation that GE is looking to shed $ 20B of assets by 2019 suggests to me that it is looking to right-size back farther toward its core. Management clarified in the conference call that this is about $ 20B of asset value, not sales, thus perhaps 10% of the company given that its market cap is now around $ 200B.

Since I believe that giant corporations such as GE have their greatest chances of overcoming troubled times when they return to their roots, I like this strategic trend.

In order to keep the article concise, I will make just a few points about a busy, complex quarter.

A few points about Q3

This was an interesting quarter.

Page 5 of what GE calls the webcast’s press release shows that earnings from continuing operations attributable to GE were down 9% yoy, from $ 2.1B to $ 1.9B.

However, a negative tax rate brought net EPS down less, -5% yoy, from 22 cents to 21 cents per share. This is actually a much better GAAP comparison than in the first 6 months of the year, but all the special charges throughout the year mean that the comparisons are relevant in one sense but not predictive of the future in another sense.

In my first GE article, I did more of a detailed discussion of operations than I want to do here, in order to be respectful of your time and, more important, to keep the article focused on the stock price and dividend, which are the overriding reasons for you to consider the points made herein.

Thus, I want to move on to make a few comments on the collapse in margins in the Power segment, GE’s largest.

Did GE do a classic “kitchen sink” maneuver with Power?

I have to wonder about this.

No doubt there were execution issues, such as too much inventory and other somewhat unspecified problems; plus changing market environments. However, sales in Power were down 4% and profits down vastly more, a full 51% yoy. This is so extreme that the fact it is being disclosed in a new CEO’s first quarter makes me suspicious that we could be getting set up for an upside surprise in Power later, perhaps relatively soon. What better way to show new management delivering for shareholders? (I’m not cynical, just an old man who thinks that most tactics are variations on old themes.)

The company describes GE Power as having 6 arms, as it were:

  • gas, such as gas power plants and gas turbines,
  • steam, such as steam power plants and steam turbines,
  • reciprocating gas engines,
  • nuclear power,
  • services (various), and
  • software.

GE also mentions on its web page that:

GE technology delivers 1/3 of the planet’s electricity, and each day we add enough power capacity to support 100,000 people around the world.

This is impressive stuff. The forerunner of this focus goes back to Thomas Edison, and in addition to GE Power, think of all the Edison companies, such as Con Ed (ED) and many others.

How could this important giant division go very bad with little warning?

Power sales were down only 4%, but orders were down more. Within this and other business segments, GE differentiates between two buckets, as follows for Power; from p. 4 of the webcast presentation, order for:

  • equipment were $ 3.9B, down 32%,
  • services were $ 4.4B, up 1%.

This looks like about a 19% combined drop in orders, which is bad but nothing like a 51% drop in profitability.

GE insists on the conference call that Power is intrinsically strong based on GE’s technical and other capabilities. I do not doubt this assertion, though it must now be proven.

As with so much of GE, there is a “black box” aspect to this. I would be hopeful of a turnaround here, and that perhaps Power is at least a little less troubled than Q3 results suggest, and perhaps could have better prospects.

So I’ll be watching this specific story carefully, and noting that if Power turns around nicely, whether other problems will be disclosed that also need repair.

Overall, my guess is that a classic pattern is being painted that tends to buoy the stock price for a while. Expanding on this idea:

Why GE may right the ship, at least according to stock traders, for a while

With Jack Welch’s heir Jeff Immelt also history, GE is very free to become a “new and improved” GE, at least as solid an investment as its somewhat plodding competitor United Technologies (UTX). UTX has the better stock chart, steadily rising dividends, and a greater focus within business lines. Now that Mr. Welch’s heir is not only gone as CEO but suffered the indignity of earlier-than-planned removal as chairman; and the long-serving CFO is leaving, GE can truly paint itself as undergoing a full root canal or two, not just a face lift. If UTX can raise the dividend without fail every 5 quarters and keep its stock trudging upward, that’s a minimum target that GE can propose to its shareholders. I would expect this to be credible for some time and to support the stock.

That Mr. Immelt did not stay until January as chairman, that Mr. Bornstein was made to somewhat humiliate himself in his final prepared remarks as outgoing CFO, and the general tenor of the conference call about the utter unacceptability of Q3 results struck me as making the case that the new team should be given lots of time to clean up the wreckage – and then growth will resume.

Thus, in thinking about GE and its shrinkage back toward its roots as an industrial giant with a health care division, I look with fresh eyes at such basic parameters as price:sales and price:book metrics to think of whether this argument will be credible with sophisticated investors.

I think it will because P:S, P:B and other metrics that get away from GE Capital and severely shrunken margins in Power, GE is roughly in the range of UTX and other leading manufacturers of “things that go rust in the night,” as the phrase from the 1980s went. (GE is promoting itself as a digital company now, but basically it designs and sells “stuff” rather than electrons.)

So, GE can look OK to investors so long as it begins to keep the promises that Mr. Flannery, the new CEO, and Ms. Miller, the new CFO have made.

It is an almost inexorable fact of mega cap corporate life that the institutions and long-time shareholders are going to tend to give the new team time to clean up the mess.

This is also known as a honeymoon period.

Exactly how they price GE over the next couple of weeks is unpredictable, as more information is provided by the new team, much of it direct to investors next month, but the honeymoon period looks to me to be off to its usual start.

That leads to my thoughts on the stock right now.

GE as having at least balanced upside potential and downside risk into next year

In my July GE article, I proposed a $ 15 price target. The term “price target” can mean different things to different people. I would not be so bearish given how amazing the momentum of equities has been since July. Stocks have now risen a record 9 straight months this year, and are on track this month to extend that record to 10 months. This sort of momentum is not easy to derail, especially when two independent forecasters, the Conference Board (which calculates the Leading Economic Indicators) and ECRI see no chance of a recession any time soon.

These sorts of market environments lead me to think of reasons for the Street not to be harsh to GE, even if its faltering cash flows and various troubles would lead to a sharp markdown of the stock price in a flat stock market.

One factor favoring resilience includes the “Dogs of the Dow” phenomenon, where megacap stocks, especially Dow stocks, attract dip buyers. And GE has had quite the dip relative to its Dow peers.

Another factor is the calendar. We are near, and possibly in, the tax-loss selling period in the United States. This has been one great year for equities; most investors have, or can realize taxable gains. GE may already be in the process of being dumped from taxable portfolios to offset those realized or realizable gains. Typically, tax-loss selling abates by mid-December, helping to set up the “Santa Claus” rally that arrives most years

Another reason to think about being constructive on GE for a while relates to questions about the dividend. This is discussed next, as it deserves its own section.

Will GE cut the dividend?

GE’s dividend peaked at $ 1.24 annually, then in June 2009 was slashed to $ 0.40 annually (paid quarterly). This has only climbed back to $ 0.24 per share in Q4 2016. (Author’s Note, October 22, 2017: This is a correction of my previous error, per comment below from NT 61.)

Given the issues with Power, GE Capital and loss of cash flows from assets to be sold, two related questions were asked by Steven Winoker during the conference call that got right to the heart of the matter:

So how is that level of dividend sustainable without jeopardizing the future growth of the company? And can you give us some sense of what you see as a sustainable payout ratio, may be something closer to 40% to 50%?

Management spent a good deal of time not directly answering either question. First, Mr. Flannery made several points. The most relevant quote I see from them was this (transcription error corrected by me):

But bottom line I’d say total shareholder return we’ll come back to you in November with the final assessment.

That is not unduly encouraging.

Next, the incoming CFO, Jamie Miller, also made several points. She spoke about headwinds and tailwinds, but also did not come close to answering Mr. Winoker’s questions.

So, the dividend is an open question.

I believe the odds favor retaining the dividend, given its importance to so many shareholders and GE’s many assets that if needed can be sold.

If management reaffirms that the dividend can and will be paid at its current level, or even raised a penny per share per quarter in 2018 or 2019, that could boost the stock price.

Time to wrap up.

Concluding comments – reasons not to love GE beyond a bounce

Longer term, I’m not in love with GE’s focus on energy, and one reason I was so bearish on the stock at $ 30 was the Baker Hughes (BHGE) deal. I had always thought of GE as doing “sunrise” technologies, such as alternative energy. I was thus shocked that it was going retrograde despite being a vocal proponent and marketer of renewable energy.

However, in the short term, oil prices could be ready for a catch-up bounce, having lagged copper and gold for some time now.

A second reason to be cautious on GE beyond a honeymoon period is that Mr. Flannery is not a technical expert. His history has been that of a financier. I’m not convinced that this is what GE needs in a CEO at this time, and I also would prefer that the chairman and CEO positions be split, following best practices guidelines.

In a knowledge-driven company such as GE, the CEO is best off being a person who knows a lot about technology.

The job of people who report directly to a CEO, such as CFO and COO, is to know how to regain operating efficiency. The CEO does not have to be the expert on that part of running the business.

The job of a CEO of a conglomerate is best filled by someone who deeply understands what makes the company special. Thus: how can GE return to organic growth? Rather than who should be fired, something IBM (IBM) has been doing for years, I’m more interested in who should be hired. After stopping the bleeding, which a good CFO/COO team can do with the approval of the CEO, how do you make GE great again?

Underlying this concern is that I do not accept that GE has lagged so badly just because it wrote poor long term care insurance and so on in GE Capital, or that the Power division ordered too much inventory recently.

Rather, it is up to GE to disprove that the “never one roach” does not apply to its problems at Power. Or, if one thinks of the long-running problems at GE Capital, perhaps one should modify that to say that two roaches have now been seen. Never just two roaches? If there are two, maybe there are 3, 5 or 10. I would not bet my money long term on Power being the last of the negative surprises.

So: GE is planning to shrink, perhaps by $ 20B of asset value. It will be trading long term earnings power for short-term cash: a policy of weakness. I expect it will try hard to retain the $ 0.96 per year dividend rate. As the analyst asked, what earning power will remain? What if Baker Hughes GE is a long-term drag on operations?

Then there are all the cyclical stock market issues. The Fed has begun to shrink its balance sheet. Enlarging it was good for P/E’s and may have helped economic activity. By analogy, that the Fed is shrinking its assets (i.e., destroying base money) may pressure both P/E’s and cyclical economic activities. This could tend to push GE stock toward where I would peg fair value, in the teens based on my guess of its realistic mid-cycle earnings power in a world that is trying to move away from emergency measures such as quantitative easing and that is trying to move away from fossil fuels.

In summary, I would propose three takeaway thoughts for your consideration:

  • GE is doing the right thing in concept in shrinking down to an industrial company and returning toward its roots in power generation, but its large investment in oil and gas may have been a material long term mistake.
  • this looks like a classic set-up for a honeymoon for new management and a reversion-rally, perhaps into Q1 next year, so short term the stock may have completed or may be nearly finished with its sell-off.
  • longer term, GE’s problems may be too deep-seated to be easily or quickly fixed, especially by a CEO whose background is more in finance than industrial operations.

Thus, I propose first that GE stock could be interesting from the long side either right now or on a further dip as we move into classic tax loss season.

Second, I propose that because GE has not yet gotten cheap to its peers, because we have no way of knowing just either how remediable GE’s problems really are or whether new management is the right management to fix them, and because Fed tightening may be especially hard on stock prices of companies that are in a weakened state, there is no clear reason to make a long-term commitment to GE with fresh money for some time to come. Downside risk to the stock may be significant, and returning GE to sustainable growth may not be an easy task.

Thanks for reading. I look forward to any thoughts you would like to contribute to the comments thread.

Disclosure: I am/we are long UTX.

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.

Additional disclosure: Not investment advice. I am not an investment adviser.

Tech

Carol Humphreys