GE – Already on the Second Envelope*

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley / Nick Lipinski

203.901.1629/203.989.0412

gcopley@/nlipinski@ssrllc.com

November 6th, 2017

GE – Already on the Second Envelope*

  • Mr. Flannery did a spectacular job in his interview with CNBC on the day that the company reported earnings. He gave the impression that he knew what needed to be done and that he was going to fix things.
    • However, this was an interview filled with generalities; the admission that mistakes had been made, businesses poorly run, costs too high etc.
    • The November “report back”, next week, is where the rubber will actually hit the road because he has to talk about specifics – with numbers!
  • Two things are critical for both Mr. Flannery and GE at this meeting:
    • That he tells the truth about everything, with no skirting of difficult questions; and,
    • That he sets expectations that he knows he can meet.
  • GE has spent years over-promising and under-delivering (Exhibit 1). Investors need the confidence that Mr. Flannery knows why history is what it is and HOW he is going to stop it.
    • If that requirement is at odds with keeping the dividend then it should be cut. The performance of the stock over the last two weeks is driven by the expectation of a cut.
    • If he promises a cash flow that supports keeping the dividend, and then misses, we go back down the rabbit hole and his tenure at GE will be short.
  • If the answer is cut the dividend, in our view GE should announce it before the meeting, as they should with any other major strategic initiative:
    • The meeting can then focus on the future – how the company is going to regroup – or split and how EBITDA and earnings can grow from here.
    • Any dividend/strategy questions in the meeting will be considered rather than reactionary and the meeting will not get hijacked by the dividend decision.
  • One possible option is to spin both Healthcare and Energy – both with dividends – partly offsetting the dividend cut at core GE.
    • The risk is that Healthcare cash is needed today to offset the declines in Power and the poor Energy business. A strategy to stop the decline in Power must be a high priority.
    • We think that the most valuable exit strategy for the Transport business is likely an RMT with Trinity (TRN).
  • We are concerned that not cutting the dividend will be taken negatively as few will believe the cash forecast needed to support it, given recent history and the Power issues.

Exhibit 1

Source: Capital IQ and SSR Analysis

*Outgoing CEO hands successor three envelopes, labeled 1, 2 , 3, and tells him to open in sequence each time he gets in trouble. The first time comes and he opens number 1 – and the letter inside says, “blame your predecessor”! The second time comes and he opens number 2 – it says, “blame the economy”! The third time comes and he opens number 3 and it says, “get three envelopes”!

It’s an old joke, but fitting – it looks like envelope number 1 is in the trash already at GE, plus, the economy is fine! So, time for action….

Overview

John Flannery knocked the cover off the ball on earnings day, leaving the audience high on the idea that he is the guy to fix GE. In the cold light of the following days however, many woke up to the idea that GE’s dividend might not be safe! Mr. Flannery at no point on October 20th suggested that it was, instead talking about an appropriate capital allocation policy.

He can only keep the dividend if he is certain that he can guide to a cash flow forecast in 2018 that:

  • Adequately covers the dividend, while providing cash for capex and other liabilities such as pension.
  • Can be achieved without selling assets or raising debt – even if this is presented as a short term move to bridge to a better 2019 – it will not be a believable conclusion.
  • But most important – a cash flow target that he can meet.

The institutional investor base is tired of a GE that over-promises and then falls short – Exhibit 1 – which is why no-one owns the stock (Exhibits 2 and 3). In Exhibit 2 we compare GE with other industrial names and in Exhibit 3 we show the Dow 30. This ownership structure could be a blessing or a curse for GE. If the company does not inspire investor confidence in November, with or without a dividend cut, GE is the obvious stock sale to offset taxable gains in 2017 – this will likely exert further downward pressure. If GE does well in November and inspires confidence, institutions are underweight relative to other Dow Industrial names and this could spur demand and upside. Some sort of “straddle” strategy is likely the way to go for those that can do it, otherwise perhaps the declaration of the dividend will define the bottom, or at least provide for a better risk/reward analysis.

Below $20 per share, GE appears very tempting to us, but the technical risk outlined above keeps us on the sidelines and maybe the new strategy and cash priority guidelines create the floor or we simply wait until January 1st before we take the plunge.

In Exhibit 4, we suggest options for each business and we go into more detail on some of these in the analysis that follows – we have already made our view clear on Energy in prior research.

Exhibit 2

Source: Capital IQ and SSR Analysis

Exhibit 3

Source: Capital IQ and SSR Analysis

Exhibit 4

Source: Capital IQ and SSR Analysis

Exhibit 5 summarizes our normal valuation metrics – see below for further detail.

Exhibit 5

Source: Capital IQ and SSR Analysis

Buy Signals Flashing – But…

All our valuation and other “buy” signals are beginning to flash very green for GE, but there is still risk of another leg-down before we hit bottom.

  1. GE’s relative price, vs the S&P 500, it at its lowest level since we have data (1970) – Exhibit 6. This does not mean that it cannot go lower.

Exhibit 6

Source: Capital IQ and SSR Analysis

  1. GE’s relative PE has been in freefall – Exhibit 7 – but it has hit lower levels several times in the past – so this also does not yet feel like a bottom – even though the earnings are so low.

Exhibit 7

Source: Capital IQ and SSR Analysis

  1. GE’s normal earnings in our model appear to be reaching stability at around $0.95 – Exhibit 8, but this is only because we are assuming that Return on Capital has to hit a floor at some point and for the moment returns appear to have stabilized – Exhibit 9.
    1. But the power business remains a concern to us as it could drive overall returns lower again if the recent trend continues – Exhibit 10.

Exhibit 8

Source: Capital IQ and SSR Analysis

Exhibit 9

Source: Capital IQ and SSR Analysis

Exhibit 10

Source: Capital IQ and SSR Analysis

  1. You should buy a stock when everyone hates it (see prior research) and we are getting there with GE – the more hated names in Industrials (Exhibit 11) are there because they are expensive and have outperformed significantly. Looking at GE’s own history, the buy signals are strong – Exhibit 12.

Exhibit 11

Source: Capital IQ and SSR Analysis

Exhibit 12

Source: Capital IQ and SSR Analysis

  1. GE is finally not expensive on our Normalized framework – Exhibit 13.

Exhibit 13

Source: Capital IQ and SSR Analysis

So – How Could Buying GE Here Be a Mistake and Our Questions for Mr. Flannery

It all comes down to how corporately self-aware John Flannery is and how much faith he has in his team to tell him the truth. To fix the company, he has to know exactly what is wrong. This is not an episode of “House” where we can try a few diagnoses and treatments to see what works. We are past that, and in the final five minutes of the episode where the “eureka” moment arrives and the right cure is found. Investors have been through the “lets try this” part of the show and nothing has cured the company – if fact everything so-far appears to have made the condition deteriorate.

The size and scale of GE is also part of the problem – John cannot know everything and has to be able to rely on others to both accurately understand their businesses and have no fear of speaking the truth. In our opinion, Ellen Kuhlman’s demise at DuPont was in part due to her being fed overly bullish estimates of business outlooks and choosing to trust those estimates. We believe that her team was intimidated by her aggressive management style and so discouraged from providing bad or disappointing news. John will fail if this is the case at GE, but we think he has recognized that, as internal “candor” was one of the first topics used in his prepared remarks in October as he talked about changing the culture. There was an implicit admission in both his prepared remarks and answers to questions, that candor was missing at GE.

An accurate diagnosis is needed as only this can lead to an appropriate remedy or set of remedies – only this can give the company the confidence to keep the dividend or the reasons they need to cut it.

Question One – The Businesses in Trouble

Getting the right vital signs is likely going to be hardest in three areas – Power, Transportation and Energy.

Energy is simple – don’t bother – there is a “no-brainer” fix – spin it off! We have written about this previously, and in our view, there is no credible alternate plan.

The other two are much more problematic as the trends in Power look terrible – see Exhibit 10 – and while Transportation has had an improving year in 2017 – Exhibit 14 – revolutionary change is likely coming to both industries and GE needs to position itself for the future and not plan based on the past. Electricity transformed the home, factories and railways over the last 140 years – now it is transforming other modes of transportation coincident with sweeping changes in power generation and distribution modes. GE faces two game changing risks here – that the Power business sees fewer and declining opportunities to build combined cycle power plants, and the abundance of low cost renewable and LNG based power in the developing world drives increased investment in Electric Rail at the expense of diesel electric or natural gas electric locomotives. GE does not have an electric rail offering.

Exhibit 14

Source: Capital IQ and SSR Analysis

How to fix the Power business is an issue that puts us a little over our skis, but we expect a major business restructuring, possibly some shrinkage and a major write-down.

Transports is a different story and here we suggest one possible strategy.  

Growing environmental and emission goals make rail electrification a no-brainer in the developing world and in some developed regions versus traditional diesel-electric locomotives if the electricity is abundant and low cost.  This, in our view, is the big risk for GE Transport – regardless of the short-term cyclical noise.  As shown in Exhibits 15 and 16 below, not only are sales and profits trending in the wrong direction (despite the improving profit margins shown above), but on a seasonal basis the business has become much more volatile – not popular with investors.  Alstom’s deal with Siemens leaves GE Transport out in the cold – we can see why GE might want to do some sort of deal with Bombardier (for example) but we struggle to see what is in it for Bombardier or anyone else in the electric locomotive space.

Exhibit 15

Source: Capital IQ and SSR Analysis

Exhibit 16

Source: Capital IQ and SSR Analysis

We had assumed that GE would hang on to this business – not because it was good but because it is tough to see how they could get rid of it in any way that was not horribly dilutive.  The tax base is very low – so a sale is off the table.  To spin it out, such that investors would want it, would require almost no debt and a very large payout – with a strategy of running for cash and returning cash to shareholders.

It may be worth taking the hit to get rid of the negative trend and the volatility – but GE would be giving up cash flow to do so, and cash flow is the issue right now.

However, given the very low tax base, the ideal exit strategy for this business would be a Reverse Morris Trust and there is one obvious candidate – Trinity!  This would be the right deal for GE if Trinity were interested and the opportunity would be to streamline the maintenance and repair business and cut considerable costs – could be a good deal for both.

  • It is an adjacency move for both companies.
  • There is a large maintenance and repair element to both portfolios – presenting an obvious source of synergies.
  • GE may have some construction related businesses that could complement TRN’s and could be included in the deal.
  • GE has overseas sales and could help TRN develop business outside the US.
  • The combined company would have greater market cap scale than either independently.

Question Two – Dissecting GE Capital

As we have written previously, we think there is an immediate need for an accounting change – with the leasing activities of GE capital that support the other businesses placed back in those businesses so that investors can see what the real return on capital is for each group. For example, when GE invests in a leasing business that will boost demand for GE jet engines, that cost should sit on the books of the engine business – not GE capital. Same for Power, Wind and the rest.

Question Three – Is “Digital” A Big Smoke Screen?

In our opinion GE’s website is one of the worst – hard to navigate – hard to find what should be easy to find data – and an Investor Relations site that is the least useful in all of Industrials and Materials.

But, perhaps more concerning, you can’t “learn more” about any business or sub-business without being bombarded with the word “Digital” in every sentence. It is too much; and in our view GE is advertising something front and center as a core and important competence that everyone else is doing with far less fuss. To us it looks like a marketing ploy intended to garner interest by talking very 21st century for a company that has not had much else good to say. It is unlikely that “digital” is a differentiator for GE except in a few unique instances, and it is likely not a sustainable advantage nor is it a reason to “keep the band together”.

©2017, SSR LLC, 225 High Ridge Road, Stamford, CT 06905. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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