The decline of General Electric (NYSE:GE)'s stock in 2018 is largely due to an ailing power segment. And unfortunately, the problems at GE Power can't be looked at in isolation; you can't just ignore problems there and focus on the positive earnings trends in the aviation and healthcare segments.
There is a bullish case for GE, but it's not realistic to make it without a rational assessment of the near-term risks in the stock. Let's take a look at what those might be, based on the disclosures in GE's latest quarterly filing with the Securities and Exchange Commission (SEC).
What management said about Power
SEC filings aren't riveting reads, but they are a treasure trove of information for investors. No point will be more pertinent than this quote, from management's commentary on GE Power end markets: "[M]arket factors such as increasing energy efficiency and renewable energy penetration continue to impact our view of long-term demand. These conditions have resulted in downward revisions of our forecasts on current and future projected earnings and cash flows at these businesses."
Is it really such a big deal that GE will miss its guidance at Power, and is reducing its projected earnings and cash flow expectations? Surely that's all factored in the price of the stock already?
Unfortunately, it's not quite as easy as that.
The SEC and Department of Justice are watching
The first and most pressing issue is what the commentary implies for the ongoing SEC investigation into GE's accounting. The SEC is understood to be looking at Long Term Service Agreements (LTSAs) in GE Power.
LTSAs provide gas-turbine clients with the security that their equipment will work reliably over time -- minimizing equipment downtime is critical to a power generator. Meanwhile, original equipment manufacturers like GE get the benefit of a sure stream of highly profitable aftermarket parts and services revenue.
LTSAs are a large part of GE's business model -- sell low- or even negative-margin equipment (aircraft engines and power turbines), then generate long-term revenue from service agreements.
Here's the question: Does GE's admission that it's now downwardly revising its assumptions for earnings and cash flow from LTSAs mean that it was too optimistic about the revenue and earnings booked from GE Power in the past? If so, it's likely that GE will need to pay fines to, and make legal settlements with, both the SEC and the Department of Justice (DOJ). This could require billions in cash.
Underlying cash flow
The biggest reason for GE's decline in 2018 is erosion in its earnings and cash flow outlook. For example, CFO Jamie Miller started the year forecasting full-year free cash flow (FCF) generation of $6 billion to $7 billion, only to lower it to $6 billion on the second-quarter earnings call, and then declare FCF would fall significantly fall short of the target during the horrible third-quarter earnings presentation.
If GE has been making overly positive assumptions regarding earnings and cash flow from LTSAs, then analysts and investors must reduce their future expectations for GE's overall FCF.
Where's the debt-reduction plan?
It's no secret that GE's bonds have been falling recently. The market has concerns about the company's debt load, which will impair its ability to refinance maturing debt (and increase debt further, as lenders raise its rates).
The statement in the SEC filing matters, because the bond market and credit-rating agencies care a lot about net-debt-to-earnings ratios when they assess the creditworthiness of a corporate bond.
At the end of June, former CEO John Flannery and Miller outlined a plan to spin off the healthcare business, and liquidate GE's holdings in Baker Hughes, a GE Company (NYSE:BHGE). These actions would shore up GE's balance sheet and reduce its ratio of net debt to EBITDA (earnings before interest, taxes, depreciation, and amortization) from 3.5 in 2018 to 2.5 in 2020 -- in line with what credit-rating agencies typically expect for investment-grade debt.
As discussed at the time, Miller claimed that a "significant improvement at Power" was expected, and that was surely part of the assumptions for EBITDA in 2020.
All told, the problems in Power are calling the debt-reduction plan into question. Meanwhile, Miller appeared to back off the plan on the third-quarter earnings call -- claiming "substantial progress through 2020," rather than affirming the target would be hit.
Miller's commentary probably didn't impress the bond market because the debt reduction plan is a key part of how debt holders assess GE's creditworthiness.
What does it all mean for GE investors?
There's uncertainty over SEC and DOJ investigations, uncertainty over future FCF generation, and uncertainty over the debt-reduction plans. It's not hard to see the keyword here...and markets don't like that word.
However, it's not all doom and gloom. The cash calls from legal settlements, if applicable, are likely to be non-recurring events from a company that is generating long-term cash flow.
On cash flow generation and debt-reduction plans, it's clear that the market is waiting for guidance from new CEO Larry Culp, and he's said he's not going to give that until he can do it with "conviction and confidence." But he will surely give guidance in the near future, eliminating some of the uncertainty around these issues.
Given that GE's current market cap is around $68 billion, cash flow of around $4 billion for 2018 would provide a company valuation of just 17 times current FCF. That, and guidance for improvement, would make the stock look like a good value. Just don't buy it without understanding the near-term risks.