Summary Investment Thesis
To call the sentiment around General Electric (NYSE:GE) stock negative would be a gross understatement. A brief recap of the past several months explains the sour attitude toward the shares:
A reinsurance business that has not written a new policy in more than a decade and that most investors barely knew existed is now required to contribute $15B over the next seven years to bolster reserves for its long-term care liabilities.
The insurance debacle by itself forced the company to slash its dividend, which was cut 50%.
The former long-time CEO and CFO were pushed out and basically disowned by their successors for their management practices.
The company’s second largest segment, GE Power, has seen its profits crater, stoking fears that solar photovoltaic power is going to make the gas turbine market far smaller.
That’s a lot for investors to stomach, particularly those that relied upon a steady dividend. But we contend that the response of GE’s new management and the sell-side analyst community have made matters worse. GE’s new CEO has disavowed himself of his predecessor in a way that we’ve rarely seen at companies of this size. Yes, mistakes were made, but John Flannery is fooling himself if he thinks his added rigor will cure all ills with running a conglomerate that touches so many parts of the global industrial economy. It appears that he was given this new role because of improved results at GE Healthcare, a unit that he led for less than 3 years.
That period of time is simply too short to execute a strategic vision that matters to the bottom line, in our view, and those improved results might have been delivered by dozens of other executives inheriting an end market with tailwinds. Ditto for the new head of GE Power. The Power unit was caught extrapolating strong service trends into 2017, and paid the price, a mistake we’d guess most management teams would make. How often have you seen a management team post strong growth and then plan to scale back before the market turned against them. That’s contrary to the “bigger, better, faster” ethos of business. Business is optimistic by nature unless tempered by an uncooperative market response.
We understand that GE’s new management team is trying to restore investor confidence by proclaiming that the “fix it” team is here and prior management screwed up royally. But these are longtime GE executives, and the investor community has just been burned by longtime GE executives. Investors aren’t going to buy the idea that one group of GE execs is better than another (nor should they). A better approach would have been to admit the missteps, offer incremental process improvements, and remind the world that GE is run by managers, not fortune tellers (in a diplomatic way of course!).
Because new management has so distanced themselves from their predecessors, they have invited speculation from outside observers about “just how bad were the old guys?” In particular, sell-side analysts (and now the SEC) are questioning the propriety of the company’s accounting practices. Our best read as outside observers is that the GE Capital folks were banking on higher long-term interest rates to eventually dampen the potential long-term care liability. But claim trends finally triggered a revaluation of those liabilities and the jig was up. What was the incentive to revalue those insurance liabilities earlier? There was none, that’s why it didn’t happen until last year.
As for the contract asset accounting for commercial service agreements and long-term equipment projects, we note that the new CFO has defended the company’s practices and pointed out that this line item has grown with the number of units supported by such arrangements — i.e., growth in actual business being conducted. In our minds, it does raise questions about the credit quality of certain customers in what GE terms “difficult geographies” (how’s that for a euphemism?), but it does not cause us concern that GE’s accounting is inherently problematic.
In evaluating GE, we are stepping back from all of the finger pointing and hand wringing and focusing on the fundamentals of the business units that make up the company. And in our view, an objective analysis reveals a stock that is worth $21 per share. The biggest risk to GE’s value is potentially poor decisions to buy and sell businesses at the wrong times and for the wrong prices. GE’s strength is everyday management, not portfolio allocation. Our valuation assumes that the company decides to spin-off its interest in Baker Hughes given its size. This is really the only decision that makes any sense other than retaining their interest. Baker Hughes is too large to merge with another major oil services company, and selling the company off piecemeal makes even less sense from a value perspective. We have assumed that the Transportation and Lighting businesses will be sold, but have not factored any other portfolio changes into our analysis.
GE stock is a buy for investors with patience and the ability to ignore sell-side pundits and the media. What follows is a brief outlook for each business and a summary of our valuation exercise.
The future for GE’s jet engine business continues to look bright. Boeing expects annual airplane delivery growth to average 3-3.5% over the coming two decades, driven principally by strong growth in China, India, southeast Asia, and areas of the middle east that serve as a linkage between East and West. Boeing is a biased observer, but recent history bolsters the credibility of their outlook and it likely would take a major economic depression in China and other major regions to knock the long-term outlook off track.
In addition, GE’s market position is dominant when you factor in the company’s CFM International joint venture. Engines sold and serviced by the 50% owned venture with Safran Aircraft Engines combined with GE’s own engines means that GE powers roughly two out of every three flights in the sky each day. Recent deliveries and design wins suggest this share will remain stable.
Source: GE public filings.
However, our modeling suggests that GE Aviation’s operating profit is now about 15% above our mid-economic cycle estimate after 5 straight years of very strong growth. We project mid-economic cycle operating profit of $5.8B, vs. the $6.6B of segment profit delivered in 2017. One watch area in the near-term will be the profit margin trend as CFM ramps its production of the LEAP engine. Unexpected manufacturing issues could put a dent in profits, at least temporarily.
GE’s Power business has come under great scrutiny after results deteriorated dramatically in 2017. On the surface, it’s puzzling that a business dominated by gas-fired turbines should struggle given persistent growth in global electricity demand coupled with a push for cleaner fuel sources. The U.S. Energy Information Administration’s base case for growth of natural-gas generated electricity is about 2% per annum. Only renewable power sources are expected to grow faster. However, worldwide gas turbine orders this year are expected to be roughly half of the level demanded just two years ago. There is a growing narrative that renewables will be able to replace much of the peaking electricity demand currently filled by natural gas-fired plants, particularly as battery storage costs decline.
Source: U.S. Energy Information Administration, International Energy Outlook 2017.
Perhaps some of that fear is justified, but the reality of intermittent electricity generation from wind and solar means that more reliable sources of power must provide the base load of the electrical grid in most places. And the bulk of the deterioration of GE’s Power results in 2017 was not the result of weaker demand for heavy duty gas turbines. The biggest problem was that service revenue fell off a cliff, and that has nothing to do with the long-term economics of power generation sources.
It appears to us that that the collapse of the price of natural gas in late 2014 through 2015 contributed to strong growth of upgrades to older installed heavy duty gas turbines and higher utilization of merchant gas power plants. Higher natural gas-fired plant utilization contributed to greater outages and need for service from GE. As natural gas prices recovered during the latter half of ’16, the payback on upgrading older gas turbines became less compelling, and marginal gas generation assets were utilized less. Unfortunately, GE extrapolated strong service trends into 2017, resulting in a lot of excess inventory of plant upgrade kits and too much manpower.
Below is a chart of the Power segment’s service orders on a trailing four quarter basis. The constantly changing nature of GE’s business segmentation muddies the picture a bit, but we think this is a fair representation of the largest businesses in the segment. Service orders last fell off in 2013, coincident with a recovery of natural gas prices from lows set in early 2012. Our hunch is that the changing fortunes of GE’s Power services business is mostly a function of natural gas price fluctuations, and that a cyclical recovery lies ahead.
Index of Power Services Orders since 4Q12 (trailing four quarters)
Source: GE company public filings and ArcPoint Advisor estimates.
Likewise, equipment orders for gas turbines have been lumpy historically. It is premature to interpret the drop off in new orders over the past two years as a signal that global electricity generation is going completely in the direction of renewables. We would note that additions of coal generation capacity easily outstripped natural gas generation capacity in 2016, but nobody would argue that coal is the future (though its cost advantage will keep capacity additions strong in developing markets for years to come).
Our modeling suggests that GE Power’s mid-economic cycle operating profit is $5.5B, nearly twice the $2.8B of adjusted segment profit posted in 2017.
Second only to Siemens, GE is a global leader in diagnostic imaging equipment. GE Healthcare will continue to benefit from aging populations in the U.S. and Europe and modernization of health systems in emerging markets (both aging and modernization factors apply in the case of China). Countering these trends will be an increasing cost burden born by the consumer in the U.S., as well as the rapid consolidation of U.S. medical providers in an effort to gain efficiencies in the delivery of care. GE Healthcare has enjoyed two strong years of growth across geographies and registered segment profit of $3.4B in 2017. Our modeling suggests mid-economic cycle operating profit is $3.0B, about 13% below last year’s strong results.
Oil and Gas
The most recent cyclical bottom for Baker Hughes (62.5% owned by GE) likely has passed. North American drilling activity has recovered along with commodity prices and international land drilling and offshore drilling activity have stabilized. Upstream service revenues should continue to recover in 2018, though longer cycle businesses like subsea trees (used in offshore oil & gas production) could take years to normalize. Our modeling suggests that GE Oil & Gas’ mid-economic cycle operating profit is $2.0B (excluding the share of earnings attributable to minority shareholders), well above the $900M segment profit recorded in 2017.
The outlook for GE Renewable Energy, dominated by the wind turbine business, is mixed. Wind turbine demand likely will be steady to slightly higher over the coming years, as suggested by the International Energy Agency’s forecast (see their Renewables 2017 report). But growth in renewables increasingly favors solar photovoltaic as costs have come down. And unlike the dominant market share GE enjoys in jet engines and heavy duty gas turbines, the wind turbine market is much more fragmented. GE management has cited increasing price competition as an issue in recent quarters. Our modeling suggests GE Renewable Energy’s mid-economic cycle operating profit is $700M, consist with the $727M posted in 2017.
The ever shrinking GE Capital business has become less valuable in the wake of a massive adjustment to future claims expectations for long-term care insurance. Management expects ongoing earnings of ~$500M annually beginning in 2020. However, that would represent a mere 0.37% return on assets and 3.7% return on equity. More typical returns for this type of business would be on the order of 1% on assets and 10% on equity, implying earnings potential of ~$1.35B annually. Our modeling splits the difference between management’s guidance and this more typical profit level, yielding a mid-economic cycle net profit of $925M.
GE Capital Balance Sheet 2019E
Source: Company filings and ArcPoint Advisor estimates.
Putting it all together
We project mid-economic cycle segment operating profit of $17B for the five industrial business units expected to be retained (or spun). On an after-tax basis, we project industrial net earnings of ~$8.5B, or roughly $1 per share. Applying a 21.7x P/E multiple (our estimated current market P/E multiple on mid-cycle earnings for large-cap U.S. stocks) implies a value of $186B, or $21 per share, for the retained industrial businesses.
Value of GE Industrial Businesses ex. Pension Deficit ($M)
Source: ArcPoint Advisor estimates.
We peg the value of GE Capital at $14B, or ~$1.60 per share. This valuation assumes $925M of mid-cycle earnings, capitalized by an estimated 15.2x P/E multiple (our estimated current market P/E multiple on mid-cycle earnings for large-cap U.S. financial companies).
Value of GE Capital ex. Pension Deficit ($M)
Source: Company filings and ArcPoint Advisor estimates.
Our total estimated share value for GE is $21. To arrive at this figure, we first sum our equity values for the retained industrial businesses and GE Capital. We then add an estimate for the net after-tax proceeds of a sale of the Transportation and Lighting businesses of $9B. We assume these two units are sold rather than spun-off and that the taxable basis is effectively zero. Finally, we deduct our estimate of how much capital would be required to fully fund GE’s pension based on figures provided in the most recent 10-K. The pension hole is so large that it effectively cancels out the combined value of GE Capital and expected asset sale proceeds!
Value of GE Shares ($ in M, except per share data)
Source: Company filings and ArcPoint Advisor estimates.
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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.