General Electric (GE 1.99%) stock has been on a roller coast ride of ups and downs for a couple of years now, with its latest climb exciting some investors. But be wary as this ride appears to be perched at the top of a hill and ready for another descent.
The stock recently hit a 52-week high of $12.24 a share. This improbable start to 2020 came, oddly enough, after a tumultuous 2019 when the company faced accusations of accounting fraud and uncertainty about its aviation division, one of the last remaining crown jewels at what was once a global empire of finance and technology. Last summer, in response to a research report alleging that the company was hiding $38 billion in losses, the stock tanked to a 52-week low of $7.65 a share in August.
But GE stock ended 2019 as one of the market's stellar performers of the year, rallying 53% in total. At this level, GE stock may be overvalued. Concerns about GE's aviation business caused by the grounding of the Boeing (BA 1.63%) 737 Max as well as over-optimism about assumed revenue growth rates from the defense sector will likely weigh on the share price for months to come. The fundamentals are weak to support General Electric stock as a long-term buy. Here's why.
A GE90 jet engine sits on the factory floor of a General Electric engine plant. Image Source: General Electric.
Flying sky high, but about to hit turbulence
The sharp dip in General Electric's share price last July was in response to a scathing public criticism about highly aggressive accounting.
Whistleblower Harry Markopolos, known for spotting the Bernie Madoff Ponzi scheme and reporting his concerns to the SEC years before the scam became public, issued a research report on GE over the summer. It accused the company of aggressive accounting and massively under-reporting losses of some $38 billion, including $29 billion in losses from its long-term-care unit. Markopolos warned investors that GE could go bankrupt in the next recession if hit with mounting losses in long-term-care insurance and falling cash flow. Markopolos added that GE would likely not be cash-flow positive in 2020, as management had predicted, and pointed to declining liquidity.
The accusations of aggressive accounting and unreported losses were met with a robust defense by GE's Investors Relations team. Since then, the market appears to have shrugged off the report and instead chose to rally behind GE, partially because of the company's booming jet engine business. Yet, questions remain about how GE has accounted for funding reserves set aside for long-term-care insurance liability and exactly how accurate -- and possibly fraudulent -- the reporting of liabilities has been.
Instead, in recent months the market has focused on GE Aviation, the last remaining crown jewel at what was one of the largest corporations in the world. The aviation business, consistently the most profitable unit for GE, serves major aerospace manufacturers, such as Airbus and Boeing.
GE Aviation is also a major global defense contractor. During times where the potential for war increases, defense-related stocks typically rally. Discussion about the Trump Administration and its war posture toward Iran has ramped up significantly in the past few months, with some observers even going so far as to predict that the U.S. will launch an outright attack. The SPDR S&P Aerospace and Defense ETF recently closed at a 52-week high and is up almost 40% over the last 12 months based on the concerns.
GE Aviation supported by a cloud of hot air
GE stock has undoubtedly benefited from this general rally in defense stocks. While the sector rally may have driven GE share price, defense spending certainly does not drive GE's overall revenue. GE's defense business is only a fraction of total revenue, accounting for just 13% of GE Aviation sales and only 5% of GE total revenue. And the very recent easing of tensions with Iran has leveled off the defense stock enthusiasm. Simply put, the bullish attitude in defense stocks may have overly inflated GE stock.
A GE9X engine is tested in an outdoor simulator at a GE research facility. Image source: General Electric.
A much bigger slice of GE Aviation revenue comes from sales of engines to Boeing. Sales to Boeing account for some 70% of overall GE revenue. GE manufactures jet engines used on the Boeing 737 Max through CFM International, a 50/50 joint venture with the French Aerospace firm Safin. In December, Boeing finally suspended production of the 737 Max because it has been unable to adequately address concerns about the safety of its showcase passenger jet following two deadly crashes in 2019 related to software issues. With Boeing's suspension of production, GE will take a hit to its cash flow -- something it can ill afford. For 2019, GE management estimated that it generated $1 billion in revenue from supplying CFM engines for the 737 Max.
Issuing a sell recommendation for GE stock, JPMorgan analyst Stephan Tusa wrote in a report, "Given a myriad of moving parts outside of just historical performance, we believe there is justification for a materially lower equity value and see (GE Aviation) is closer to its best days being behind it than in front." Tusa added that GE Aviation is "almost 100%" of the value that shareholders perceive in the full (GE) company.
What's a long-term investor to do?
It's looking less likely there will be any near-term war with Iran that will drive defense sector revenue. Nor does it look like GE will be selling engines for the Boeing 737 Max anytime soon, particularly given the 400 competed planes Boeing has sitting in storage, still waiting to be delivered. The recent rise in share price appears to be a jump related to short-term news only.
GE still has major problems with potentially massive growing-yet-hidden liabilities on the balance sheet. Further, GE Aviation, accounting for less than 40% of total revenue, now seems to be supporting the valuation of the entire company. GE stock price has rallied, but it may have gone too far, too fast on a cloud of optimism over aviation. It's not a stock to add to your portfolio.
