Friday Findings – March 2nd, 2018
SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES
Graham Copley / Nick Lipinski
March 2, 2018
- Chart of the Week
- GE – Looking For Good News – But There Is None!
- PX/LIN – The Size Of The Divestment Is Irrelevant – Whether The Deal Gets Done Is What Matters
- Weekly Winners & Losers
With most earnings reports behind us we have another very strong showing of growth from Industrials and Materials. The strength in 2011-2013 was a function of rising off the post-recession lows of 2009 and then a raw material boost from oil. The strength today is not pushed by oil (although oil pricing is higher than a year ago), nor is it a bounce off a low – it is driven by demand strength, with revenue gains coming from pricing (especially in materials) as well as volume. Oil has provided some raw material pressure but the earnings growth trajectory shows that companies are getting volume and price to more than offset this, suggesting that order books are robust. This looks like “economics 101” and consequently, while further strong growth is likely to be very good for earnings for both segments of the economy (probably Materials more than Industrials), it will likely be a driver of inflation as pricing will get passed through to the consumer to some degree as it is the consumer that is causing the demand strength.
Many of these industries have not experienced real reinvestment economics for decades – with part of the reason being the ability to expand capacity/production for years through cheap capital increments or other productivity gains. Return on capital is only above a trend that supports reinvestment for Conglomerates. It is also above trend for Metals and Paper and Packaging, but in both cases the trend does not support reinvestment. Most segments would need to see a further boost in profitability to justify significant new capital spending. The US tax cuts may be enough to swing that decision where investment in the US makes sense, but we expect further pricing and margin expansion in 2018 as little can be done to improve supply in 2018.
The industries that look most interesting from an investment perspective are the Materials sectors – Chemicals, Metals and Paper/Packaging, but many Capital Goods and Electrical Equipment sub-sectors need further margin expansion to drive what is likely needed investment. Our stock preferences are summarized above.
Every day someone buys GE’s stock, and lots of it, given the daily turnover. These are the optimists – those who think it can’t get any worse and we must be close to or at the bottom. But it does get worse and we still may be a distance from the bottom.
GE cannot provide any good news because, in our view, it does not have any, and likely won’t have any for some time, if ever. Cupboards are being opened at GE, something John Flannery has no choice but to do, and skeletons are everywhere. Earnings are being restated for 2016 and 2017, confirming the long-held concerns that there was something amiss with the disconnect between earnings and cash flows. The cash flow story was right – the first rule we were taught as analysts – cash flows don’t lie – or at least find it harder to lie. Even the announcement this week of three (in our view) well-chosen new board directors could not lift spirits. Investors did not get Ed Breen as a possible alternative to John Flannery with break-up experience, but they did get Larry Culp who is a good second choice.
With the release of the new 10-K we get yet another increase in goodwill and other intangibles on the balance sheet – chart below – this time from the Baker Hughes deal. Given the state of the various businesses, especially those in which there have been recent acquisitions – driving goodwill (Alstom and Baker Hughes) – investors are likely to see further write downs as the year progresses. GE and Mr. Flannery cannot move forward until they have a clean sheet of paper – and they appear far from that now. They cannot sell anything major without a significant cost restructuring or the stranded costs will consume all of the cash flows. Equally they cannot split the company until the costs and the balance sheet are under control. All of which suggests another round of cost cutting and write downs before any real progress can be made – without these moves the company is simply playing around the edges of the real problems.
While the internal mess is being addressed at GE, its largest market – Power – is under all sorts of external pressure from changes in the investment outlook of major customers as renewables and storage have an increasing impact on strategy – please see work published by our colleagues Hugh Wynne and Eric Selmon this week, which is directly relevant to GE and its power supplier competitors. The risk for GE is that the changing power market is causing a rearrangement of the deck chairs – consolidation and alliances between power equipment suppliers – and that when GE is ready to look outside its own walls and play, with a clean deck of cards, the game could be largely over, with GE the loser. We do not have enough data to suggest that the stock is cheap enough today to weather what we think will be another wave of restructuring/write-down news flow.
News that PX and LIN are working on the divestment program required to satisfy regulators is good, as it means that the companies are working towards a solution. This is also a situation where the companies can probably identify with almost 100% certainty 90% of the assets that have to be sold – the noise and the debate with the regulators will be around the last 10% (perhaps 15% at a stretch). The size of the divestment is largely immaterial to our investment thesis as we are not basing our recommendation on the combined company’s ability to run its existing asset base better – although this is a possibility and further upside.
Our positive stance on the deal is driven by three factors:
- The large share buyback that the divestments and the high cash flows will enable;
- The very high synergy potential, which is mostly head-office overhead and minimally impacted by the level of required divestments;
- And the ability of the combined company to win more profitable new business going forward at prices that allow the new company to make adequate returns but not others.
The recent commentary suggests that the lost EPS from divestments may be incrementally higher in the chart below, but this would be partly offset by higher share buyback. Otherwise nothing has changed with respect to our original analysis – summarized in the chart – except perhaps that pro-forma 2018 may be a stronger jumping off point because of the better industrial outlook. This remains our best single stock investment idea for 2018.
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