Business

General Electric: The Recent Report (Rumor) Was Music To My Ears

It was recently reported that General Electric’s (NYSE:GE) management team is now considering several options to dispose of major business units, which could include spin-offs and/or “hybrid” deals with other companies. There are also rumors that the Transportation division could soon be spun off into a separately traded public company. All of this news is music to my ears (more on this below), and the only question that I really have now is, “What took so long?” Since the company’s 2018 Investor Outlook meeting, GE stock has been in a free fall and has significantly underperformed the broader market.

Chart GE data by YCharts

I believe that most (if not all) of the downward pressure for the stock was a direct result of the uncertainty related to what this once-great industrial conglomerate may look like in the years ahead, which is the main reason why I am so encouraged about the recent news – remember, where there’s smoke there’s fire. In my mind, the company’s path forward is slowly starting to become a little clearer.

Does this make GE shares a buy? No, not necessarily, but it does somewhat change the narrative – that is, major asset sales/spins should be considered positive developments. Let’s take a moment to consider where this company has come from before we jump into where it is (may be) heading.

Where Did “We” Come From? The Same Old Story

Looking back, General Electric’s downfall was actually well-telegraphed and should have been easy to avoid (this is me kicking myself). GE was known as the master of managing its earnings, as shown by the fact that the company beat estimates in 7 out of 8 quarters from late 2015 to mid-2017.

General Electric: The Recent Report (Rumor) Was Music To My Ears

Source: Fidelity

The writing was, however, on the wall, of course, if you were willing to factor in the company’s poor organic revenue growth (or lack thereof), falling order numbers, and poor cash flow metrics. Now, all of a sudden, the skeletons have started to fall out of the closet, and the company’s operating results fell off a cliff. Lately, this once-market darling cannot seem to get out of its own way.

Additionally, the timing for GE’s real tumble – the stock price falling from the $30 per share range to the mid-teens – just so happened to coincide with the departure of Mr. Jeff Immelt, which has caused many pundits to point their fingers at the previous CEO and his minions. In my opinion, it is somewhat telling that GE only recently discovered the insurance issues that resulted in multiple billion dollar charges and that the company’s aggressive accounting of servicing contracts in the Power unit only recently came to light. What does all of this tell us? I believe that it tells us that GE’s accounting was a major issue under Mr. Immelt. Additionally, I believe that these types of concerns/issues had to be flushed out before the company could really move forward, even though many experts point back to the company’s aggressive accounting under Mr. Jack Welch as the starting point for the accounting trickery.

As a long-term shareholder, I say all of this simply to say that I am encouraged that the bad news is finally starting to come out and that Mr. John Flannery seems ready to usher in a new era. GE is leaving behind a period of time that saw the previous management team make plenty of capital allocation blunders, which lead to them creating a hodgepodge of a conglomerate that appears to be too complex to manage (of course, only in opinion).

Where Are “We” Going? The Story Is Changing

A few months ago, I wrote a piece and described to the Seeking Alpha community what I thought would be the ideal path for GE to take. I have long believed that GE should make major structural changes to its business in a direct attempt to streamline operations and unlock value, and I identified the following “dream” transactions in the article linked above:

  • Sell (or spin off) Transportation and Lighting.
  • Spin off Baker Hughes, a GE Company (NYSE:BHGE).
  • Spin off Healthcare – it pains me to say it, but I believe that this business is more valuable as a standalone company, which is also the reason why I want the unit to be spun off instead of sold.

With the most recent rumors that GE may soon be announcing a broader restructuring plan, I think that Mr. Flannery and team are finally starting to realize that the market will not be happy with a slow recovery that includes only $20 billion in assets. Moreover, I would not discount the pressure that Mr. Flannery and the board are currently under to right the ship, or at least come up with a more impactful restructuring plan.

In my opinion, I do anticipate that GE will break itself up at some point in the next five years, but I see the company doing it in a more orderly fashion. The company has already announced several small asset sales, with the ~$1 billion sale of its healthcare IT business to Veritas Capital being an example, which are indeed steps in the right direction. And I still expect for Baker Hughes, a GE Company, to be a standalone entity within the next 36-48 months and for other smaller transactions to occur over the next 12-18 months, but in my opinion, the Healthcare (or other significant business unit) sale/spin-off will likely not come in the next few years.

So, you may be asking where I see this company heading. Personally, I believe that the recent rumors are pointing to an industrial conglomerate that will look very different by 2020, if not a lot sooner.

What Do I Need to Hear In Late April 2018

Where do I begin? The SEC investigations? The deteriorating Power division results? The growing debt balance? The poor cash flow prospects? Yes to all of the above.

I believe that the SEC investigations (along with other things) will be a major overhang for the stock until the results are released and the fines are imposed. As such, I believe that the stock will not fully begin to recover until these reviews are wrapped up.

On the other hand, shareholders still need to evaluate the company’s operating results and determine if the stock is actually worth holding onto. To this point, GE is expected to report Q1 2018 results on April 20, 2018, and analysts are calling for adjusted EPS of $0.12 on revenue of $27.3 billion. For comparison purposes, the company reported adjusted EPS of $0.21 on revenue of $27.7 billion in the same period of the prior year.

The financial community has already started to bake in expectations for weak operating results from GE’s Power division, so I do not anticipate for the deteriorating fundamentals for this specific operating segment to be a real sticking point for most investors. Yes, management definitely needs to rightsize Power’s expense base and convince the market that the worst is close to being over, but in my opinion, investors should fully expect several quarters of lackluster results from this unit.

For the upcoming quarter, I am most interested in hearing about the company’s capital allocation plans for 2018, which includes what management now considers “core” businesses. During GE’s Annual Outlook meeting, Mr. Flannery provided the following slide related to the company’s capital allocation plans for the current year.

General Electric: The Recent Report (Rumor) Was Music To My Ears

Source: Investor Outlook Meeting

Two words come to mind: things change. As I mentioned earlier, I believe that the company will soon announce a broad-based breakup (or reorganization), which will obviously have an impact on its 2018 capital allocation plans. As of today, there have been several recent developments that will have an impact on GE’s capital allocation plans:

  • The dividend cut will save the company ~$4 billion in 2018.
  • The pension deficit is shrinking, but the company will still need to focus on reducing the asset-liability gap (pre-funding has already been announced).
  • Asset disposals are already having an impact, and this is expected to continue for the foreseeable future.

During the Q1 2018 conference call, I am not expecting management to provide a detailed plan for how 2018/2019 is going to play out for GE, but I do want clarity on how this company plans to approach allocating capital over the next few quarters. At the end of the day, I want to hear (and believe) that this company is allocating its capital in a manner that will contribute to GE eventually becoming a less complex, more streamlined industrial conglomerate. Contending with the short-term earnings pressure now and possibly reducing the dividend again, which will remove some of the uncertainty, may actually be great long-term decisions for this company.

Valuation – The Unsolved Mystery

Let me start by saying that, in my opinion, it is (almost) impossible to truly value GE at this point in time because there are simply too many moving pieces to consider. No one outside of management knows exactly what assets will be disposed of, so it is a little too premature to come up with a valuation for the “new look” GE or to put a dollar figure to the assets that may soon be sold/spun off.

Therefore, looking strictly at forward earnings estimates, which may actually turn out to be too high after factoring in the recent developments, GE shares are trading at 13x 2018E earnings.

Chart

GE PE Ratio (Forward) data by YCharts

Is GE attractively valued? I believe that it depends on your time horizon and how much value you place on the struggling (O&G, Power, GE Cap) and promising (Aviation, Healthcare, and Renewables) businesses, but in my opinion, a lot of the bad news is starting to be priced into the stock. However, I think the risk is still currently to the downside.

Bottom Line

The “breakup” rumors are music to my ears, because I believe that is the only way that GE will be able to move beyond its past blunders. The company’s earnings may be negatively impact by the restructuring charges, but if you are willing (and able) to look out a few years, asset sales/spin offs have the potential to create value. Not only will GE warrant a better valuation when the company is easier to understand, but the soon-to-be public stubs may also actually garner a lot of attention in today’s business-friendly environment. To this point, I believe that GE, in its current state, is bringing down the value of most of the businesses that are under its umbrella.

I do not expect much from GE when it reports Q1 2018 operating results, but the company’s capital allocation plans will be key. If Mr. Flannery is going to be successful as CEO of GE, he will have to navigate this company through the noise and make the right capital allocation decisions. Easier said than done. Warren Buffett may not save GE this time around, but it would be nice to see Berkshire (BRK.A, BRK.B) turn out to be one of the companies that enter into one of the hybrid deals that are being floated.

I plan to stay long the stock, but prospective investors would be wise to wait for a pullback before starting a position in GE.

Disclaimer: This article is not a recommendation to buy or sell any stock mentioned. These are only my personal opinions. Every investor must do his/her own due diligence before making any investment decision.

Disclosure: I am/we are long GE, HON, UTX, BRK.B.

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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