The Bull and Bear Case for GE

GE (GE -2.46%) has not had a great year, to put it mildly. While there absolutely are serious problems with the business, new CEO John Flannery's turnaround plan could present a great long-term opportunity for investors.

In this week's episode of Industry Focus: Energy, host Sarah Priestley and Motley Fool contributor Adam Levine-Weinberg present the bear and bull cases for GE. GE's aviation and healthcare arms look pretty appealing as both markets grow at huge clips, but is the multisegment company just too complicated to manage? The storm cloud of GE's $29 billion pension burden looms large, but it's not as awful as it first seems. And recent divestitures prove the company's dedication to more thoughtful, long-term strategies. Find out more below.

A full transcript follows the video.

This video was recorded on May 31, 2018.

Sarah Priestley: Welcome to Industry Focus, the show that dives into a different sector of the stock market every day. Today, we're talking Energy and Industrials. It's Thursday, the 31st of May, and we're going to be talking about General Electric's stock. I'm your host, Sarah Priestley, and joining me on Skype is Adam Levine-Weinberg. Adam, how are you doing?

Adam Levine-Weinberg: Good! How are you?

Priestley: Excellent. I'm enjoying the lack of spring in D.C. It's gone straight to summer here. It's a little rough. What about you?

Levine-Weinberg: Similar weather out here. We went from 65 to 95 in about two days. It was not quite expected.

Priestley: Wow, yeah. Back home, I think some people have had flooding, so I should count myself lucky. 

Today, we want to talk about GE. GE shareholders have been in for a very rough ride these past 12 months. The stock is down 19% so far this year. Decline really began in early 2017. The company failed to deliver on former CEO Jeff Immelt's promises. His $2.00 earnings per share goal for 2018 now seems like a joke. GE Power, the company's largest business unit, has been seriously struggling. There's kind of a myriad of previous management missteps and mistakes that are coming to the fore, and a lot of shocking revelations -- none more so than the $6.2 billion charge related to its reinsurance business that they noted in the fourth quarter.

Now almost a year into the role, new CEO John Flannery has laid out a slow and steady turnaround centered on returning the company, essentially, to financial health. He's made some really bold and difficult decisions. Within that process, he's replaced almost half of the management team, adopted new accounting rules, and cut GE's vaunted dividend in half, much to investors' chagrin. The shake-up by the new CEO extends to all areas of the business. There's one quote that I want to give from his investor presentation in October. He said, "The review of the company has been and continues to be exhaustive. We are evaluating our businesses, processes, culture, how decisions are made, how we think about goals and accountability, how we incentivize people, how we prioritize investments. We've also reviewed our operating process, our team, capital allocation, and how we communicate to investors." He says, "Everything is on the table. Things will not stay the same at GE." And he's definitely proved that that's true. 

Fill us in on some context here, Adam. What's the big picture at GE?

Levine-Weinberg: GE, for many years, was considered a role model for the American economy and for other companies. It was one of the biggest industrial conglomerates in the U.S. Particularly under Jack Welch, its long-serving CEO in the 80s and 90s, it was able to generate very substantial earnings growth and was very reliable in terms of beating its earnings targets. The problem was that, to some extent, GE's success was a mirage and it was based on, nothing illegal, but, very aggressive accounting, and also some ill-chosen acquisitions. They got into areas that were profitable for a while, and all of that, unfortunately, has collapsed in a very short time and come back to haunt GE.

In 2017, you saw a GAAP loss of $0.60 per share for the company for the full year. Their adjusted earnings were also a loss of $0.45 a share. A lot of that came from this charge that you mentioned, more than $6 billion for its long-term care insurance subsidiary. This is one of those areas that seemed really profitable a couple of decades ago, to sell long-term care insurance to people who were worried about their healthcare needs for retirement. Unfortunately, healthcare costs have gone up far more than anybody expected at the time, so these policies have turned out to be extremely unprofitable. GE booked lots of profits in the 80s, 90s and 2000s on these policies, and now it's come back to haunt them, causing that big charge.

You also saw the big downturn in the power market that Sarah mentioned. 45% drop in segment profit for Power. Since that's the largest segment in terms of revenue, that clearly hurt the bottom line quite a bit last year. The only segments that were still posting earnings growth in 2017 were Aviation, Healthcare, and Renewable Energy. In addition to the accounting losses that GE reported, it also saw a big decline in its cash flow. As a result, that forced GE to cut the dividend, as you mentioned.

With John Flannery in position -- he also has a new CFO in place, Jamie Miller -- they presented a turnaround plan to investors at an investor day conference last November. Part of that plan involves divesting $20 billion of assets by 2019. GE is also planning to exit the oil and gas market, because it sees that business as being too dependent on commodity prices. When oil prices are up, they make money; when oil prices go down, the business doesn't do well, regardless of how well it's managed. They want businesses that they can manage to drive sustainable earnings growth. 

So, as a result, you're going to see a future GE that's focused on three key markets: Power, Aviation, and Healthcare.

Priestley: You touched on a great point about the long-term care policies. I think this is something that really spanned the whole of Immelt's tenure. He would invest in the hot thing at the time. He made a lot of oil and gas acquisitions when oil and gas was at its peak. He invested at the pro cycle points on a lot of businesses, and now you're seeing the result of that. Another example would be their buybacks. They've tended to buy back very high under Immelt.

Levine-Weinberg:​ Yes, that's absolutely true. The other thing that we could talk about is, in the Power business, that got a lot bigger because Immelt went out and bought a lot of the assets of Alstom, which was a French company, also at the top of the market. That was really dependent on nuclear and gas. And all of that business has come down in a huge way because renewable energy is getting so much cheaper and more desirable.

​Priestley:​ I think that was a $10.6 billion acquisition, and I think that was the largest industrial acquisition that GE made. And as you said, it's not been profitable for them at all. 

There's so much negative sentiment around this company at the minute. If you type in "GE stock" into Google, the first five articles you're going to see are probably why you should sell GE. Can you summarize the bear case for GE right now?

Levine-Weinberg: There are basically five key things that GE bears have pointed out. The first is the long-term struggles in the Power unit. The second is hidden liabilities at GE Capital, like that long-term care insurance subsidiary that caused the charge last year. The third is weak cash flow, especially in the near-term. The fourth is weak balance sheet. And then, the fifth one is that GE is just too complicated to manage. 

To start with GE Power, as I mentioned a few minutes ago, that business is heavily focused on gas turbines for power plants. As the cost of renewable energy and energy storage has come down, that significantly reduced demand. These natural gas plants are often used as peakers to supply extra power when the grid needs a little more juice, particularly in the evening. If you have cheaper energy storage, then you can produce power at a steadier, and you don't need to pay for a whole extra power plant that only gets used a few hours a day. 

On top of this demand issue, GE was also very slow to cut costs. That probably spoke to some organizational problems, where people were being over-optimistic about how fast (unclear 8:05) would bounce back. It took a while for GE to realize, no, this downtown is for real and it's not going to recover until at least 2020. That's the company's current outlook.

The second issue is that, in GE Capital, you've moved into all these areas like issuing subprime mortgages, and long-term care insurance, and a variety of other things that aren't actually related to GE's core industrial business. Those may have been profitable for a short period, but just as the long-term care insurance subsidiary came back to haunt GE a few months ago, now GE is preparing for, potentially, a big liability related to its mortgage activities, because like many other subprime lenders, it's potentially on the hook for penalties related to mortgage fraud, from selling these mortgages to investors without full disclosure.

No one really knows what else might turn up. Those are just the two things that people really know about. And this became a complicated financial subsidiary that, investors are certainly worried about whether there's other rocks that they haven't looked under yet, and in a year or two they'll find another $5 billion liability.

Priestley: [laughs] Yeah, I hope not. As an investor, I hope not.

Levine-Weinberg: Yeah. The third thing is cash flow. The problem is that Power and GE Capital are putting significant pressure on GE's cash flow. GE Capital in particular had been paying huge dividends to the parent company, the General Electric Corp subsidiary, for several years as it was selling off its assets. Now, it's decided that it can't pay any dividends because of this big charge it had to take, and it need to recapitalize. That's, right off the bat, a $2-4 billion headwind.

GE is also looking to spin off or sell various assets. As it sells assets, many of those assets are producing cash flow, so getting rid of them will reduce cash flow going forward. As a result, there are quite a few analysts out there who are at least worried that GE may have to cut its dividend again, even after having reduced it by 50% just six months ago.

Part of the reason why analysts are worried about cash flow is that the balance sheet is also pretty weak. GE had almost $126 billion of debt at the end of last quarter. It also had a fair amount of cash. But the net debt was still quite substantial. On top of that, the pension was underfunded by nearly $29 billion at the beginning of this year. 

The high level, the last one, is just that all of these problems may indicate a broader problem of GE being too complicated to manage. The management team just hasn't been able to keep up, to keep the company performing at a high level.

Priestley: Absolutely. I think you're seeing a pattern of these conglomerates concentrating on the most profitable segments that they have, and it's not a bad business plan. I don't know that we're going to see any of these huge multi-segment corporations going forward for a while. 

You mentioned cash flow. It seems so obvious that the company has been spending too much money. 2015 through to 2017, they generated $30 billion from cash flow and asset sales, but they spent $75 billion on stock buybacks, dividends, and acquisitions. It's obvious that that's untenable.

I count myself in the very lonely camp of being optimistic about GE's prospects. I hope that people at home aren't thinking that I'm crazy, but I think the concentration on the three segments that are currently working for them, with Healthcare, Aviation -- especially Aviation, actually -- is the right thing to do.

Levine-Weinberg: Yeah, I would agree that the Healthcare and Aviation markets, at least, seem quite healthy, and probably undervalued by investors right now. Healthcare, for one thing, is a secular growth industry, just in terms of the aging of the global population. The amount of health spending has been increasing at a very high rate, and there's no reason to think that's going to stop any time soon. GE Healthcare produced a segment profit of $3.5 billion last year, and it's been growing at a mid-single-digit rate. There's really no reason to think it can't keep growing at that rate. It's not extremely fast growth, but it's definitely respectable. They could keep doing that for a decade or more.

Priestley: I read a stat the other day that said that over the next ten years, every day, there will be 10,000 more baby boomers turning 65. And as we know, healthcare costs go up as you get older, so it definitely looks like they're going to be riding this secular tailwind.

Levine-Weinberg:​ Yeah, that's absolutely true. Turning to the Aviation business, that's arguably an even stronger business. GE is the largest engine manufacturer, if you include its 50% owned joint venture, CFM. Air travel is growing extremely rapidly as the global middle class expands. In recent years, you've seen mid-to-high single-digit growth in terms of passenger travel. A lot of that is coming in emerging markets, which have really quite a bit of runway left -- pardon the pun -- for passenger travel growth.

In 2017, Aviation revenue was more than $27 billion, which put it roughly on par with the Power segment. Aviation generated a segment profit of $5.4 billion, adjusted for the new accounting rules that went into effect this year. GE recently disclosed that it expects segment profit to rise at least 15% in 2018 off of that $5.4 billion base. That's going to be past $6 billion just in 2018. And there's quite a bit of room for growth ahead, because GE Aviation gets the majority of its revenue, about $20 billion, from the commercial market. And it has a backlog there of $160 billion. That means that the Aviation business has many years of growth virtually locked in because these orders, in some cases they can be modified, but for the most part, they can't be canceled unless the entire company goes bankrupt. 

This growth is being driven primarily by the Boeing 737 Max and Airbus' A320neo family. Together, those two aircraft families have more than 10,000 outstanding orders. There's a huge amount of demand. Even if one airline decides that they don't want planes that they've ordered, there are dozens of other airlines eager to step in. So, GE has a really good position here with about three-quarters of the engine market for those two models combined.

Furthermore, those are both new aircraft families, the 737 Max and A320neo, that have come out within the past three years or so. The new engines have very high costs to build initially, which has put some pressure on GE's cash flow, and under the new accounting rules, also on its earnings. However, over time, those costs will come down substantially. I'm projecting that the cost to build one of these engines could drop by half over the next decade. That's the driving force behind margin expansion for the GE Aviation segment. Between the revenue growth opportunities and the margin expansion opportunities, segment profit could double by the mid-2020s for GE Aviation, putting it well above $10 billion.

Focusing on these two healthy business, Aviation and Healthcare, along with power, which obviously still needs to be turned around, and then a very slimmed-down GE Capital, that really ought to make GE easier to manage and get around that problem where management's being pulled in five directions at once, and therefore nothing's getting fixed at the rate that it needs to be.

Priestley: What about the concerns over the pension burden?

Levine-Weinberg: Obviously, on its face, a $29 billion pension liability is pretty bad. It's the largest of any company in U.S.

Priestley: Wow.

Levine-Weinberg: However, a lot of that has been driven by interest rates, which have been very low for many years right now. The way that these pensions get measured, the lower interest rates go, the greater that liability seems. In its recent annual report, GE said that a 25 basis point rise in the discount rate, that's increasing interest rates by 0.25%, would reduce its pension obligation by $2.4 billion. That means that if interest rates were to rise by a full 1%, that would be almost $10 billion knocked off of the pension, taking it down to less than $20 billion. Interest rates have already risen by about half that amount, roughly 0.5%, just since the beginning of 2018. So, you could definitely imagine that, by the end of 2019, or certainly sometime in 2020, you have a full 1% interest increase in interest rates. That really reduces the pension liability to under $20 billion.

Then, GE has also announced that it's going to contribute $6 billion to its pension plan this year. When you add that in, now you're looking at less than $15 billion --which is still high, but it doesn't seem nearly as unmanageable as the $29 billion number that people are looking at today. Obviously, that $6 billion does add to GE's debt load. But, on the other side of the coin, GE is starting to sell off assets, and those assets sales will bring in cash that could help GE reduce its debt over the next few years.

Priestley: We've seen the asset sale news in the media recently. I think the one thing that GE will need to do in order to overcome a lot of their current issues is to actually get out of the regular financial media. What are the headlines that we're seeing around GE Transportation, and what does that mean for the company?

Levine-Weinberg: The most recent deal that GE announced was a divestiture of its Transportation division, which mainly builds freight locomotives. It's a very profitable division historically and generates lots of cash flow, but it's still pretty small relative to GE today. It's also in the midst of a cyclical downturn, which has been a problem in the past year or so. 

Under the terms of this deal, GE is going to sell about $2.9 billion of its assets to Wabtec, which is a Westinghouse spin-off, for $2.9 billion in cash. Then, the rest of GE Transportation will merge with Wabtec. At the end of these maneuvers, the Wabtec shareholders will end up with 49.9% of the combined company. GE shareholders will have 40.2%. And then, GE itself will own 9.9% of the new Wabtec. Then, GE is required to sell that 9.9% stake within three years. So, ultimately, that will convert into cash. Depending on how Wabtec shares trade over the next couple of years, that will probably be around $2 billion of additional asset sale proceeds.

The 50.1% that GE and its shareholders will own at the beginning of this deal is currently valued at more than $9 billion, based on Wabtec's recent share price. So, including the cash component, the total deal value is actually more than $12 billion, which was quite a bit higher than what most analysts had been expecting. That's mainly because GE was taking a patient approach. Rather than trying to sell the entire business for cash to the highest bidder, it was willing to take this half-sale, half-merger deal with Wabtec that means it won't cash out as quickly, but it maximized the amount of value that GE shareholders are going to get. It's also going to minimize taxes for GE and for GE shareholders, which is obviously important, too.

Priestley: Yeah. They'd owned that business for maybe 100 years, was it?

Levine-Weinberg: Yeah, more than a century.

Priestley: The tax implications will presumably be pretty high. I think this is such a smart move by Flannery, because he's essentially being strong-armed into selling a lot of these assets while they're in a downturn. This is a way that he can game that system and get some liquidity out of them right now while also shoring up some future returns. 

Levine-Weinberg: Yes. Just to run through some of the other deals that GE has announced recently, it's planning to sell its industrial solutions unit to ABB. That's supposed to close within the next month or two and bring in $2.6 billion of proceeds. It sold off its Healthcare IT unit to a private equity firm for a little over $1 billion. That deal is supposed to close next quarter. It's marketing its Distributed Power operations, which includes the Jenbacher and Waukesha brands. Analysts have estimated that could be worth $3 billion and more. GE's Lighting division is also for sale. Obviously, lighting has become commoditized, so that's not going to bring in a lot of money, but again, it will help with making the company more focused on its main operating divisions.

Then, the last and biggest one is that GE eventually plans to divest its 62.5% in Baker Hughes. It acquired this stake not even two years ago. That's currently worth about $25 billion because of the recent surge in oil prices across the globe. But, again, this is part of the GE strategy. It doesn't want to be in these commodity businesses, where changes in oil prices are going to dictate profits. Assuming that oil prices stay high for the next couple years, this actually could be a pretty good time to get out of that business, while people are willing to pay more for it.

Priestley: I feel like we could do a whole show just on the Baker Hughes-GE situation.

Levine-Weinberg: We probably could.

Priestley: The bottom line here is that there's a lot of cash still to come, is that right?

Levine-Weinberg: Yes, and that's going to pay down quite a bit of the debt. GE certainly still has work to do to clean up its balance sheet. But right now, it's generating more cash flow than it's paying out in the dividend. About 70% is getting paid out as a dividend. And as that Aviation unit in particular grows over the next few years, that should be able to offset the lost cash flow from businesses that are being sold off. So, between the asset sale proceeds, additional cash flow from Aviation, hopefully some help from interest rates in terms of the pension obligation, it looks like GE has a good chance to get its balance sheet to a healthier state by 2020.

Priestley: And right now, I feel like it's a company that's very fashionable to be bearish about. I think that Flannery has a very good slow and steady wins the race approach. If he can have the breathing room to enact his turnaround plan -- and as you said, a lot of other things go in his favor -- then the situation might not be as dire as it's being presented.

Levine-Weinberg: I completely agree.

Priestley: Is there anything that we've missed that you'd like to add?

Levine-Weinberg: I would just note that these changes in market sentiment can come about pretty quickly. If you go back really only about two, two and a half years, people were very similarly bearish about Boeing's stock. Boeing also had very high pension liabilities, it also had some product lines that weren't doing very well, sales were low, it was cutting costs but it never seemed to be quite enough. It had accounting policies that people thought were too aggressive. And yet, a couple years later, Boeing's stock has more than doubled. It just took a couple of years of solid execution to change the market's mind. That doesn't mean that GE's stock is necessarily going to double in the next two years, but it does show that a lot of this depends on the way that people interpret the data in front of them. A relatively small change in GE's actual trajectory could completely change the way that people think about and value GE's stocks.

Priestley: A lesson for a lot of different stocks, I think, an investing lesson generally. Thank you so much, Adam, for joining me today. 

That's it for us. If you would like to get in touch, please feel free to email us at [email protected], or tweet us on Twitter @MFIndustryFocus. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thank you to Austin Morgan for producing the show. For Adam, I'm Sarah Priestley, thanks for listening and Fool on!