GE – More Margin Pressure Is The Risk

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SEE LAST PAGE OF THIS REPORT Graham Copley / Anthony Salzillo

FOR IMPORTANT DISCLOSURES 203.901.1629 / 203.901.1627

gcopley@ / asalzillo@ssrllc.com

September 4th 2018

GE – More Margin Pressure Is The Risk

  • The problem with getting more constructive around GE, even at the lower values is that a couple of the businesses may not be out of the woods in terms of both revenues and margins – with pricing a larger concern than absolute demand levels.
    • Both the Power and Renewables businesses have seen declines in revenues and margins, as demand has dropped, but the risk is now that the underutilized industry participants compete for market share and that pricing steps down further.
    • Neither has expectations for a quick fundamental recovery, and other industries show that products and services can commoditize quickly when market share gains become the goal.
  • In the manufacturing space the best example remains ethylene after the vast overbuild in the late 1970’s – which coincided with a global recession caused by higher oil prices.
    • Some discipline for the first couple of years: margins fell significantly but remained positive.
    • Eventually enough participants accepted that dynamics were not going to improve; pushed for market share – the worst year for profitability of the 5-year downturn was the last year!
  • On the services side, we have watched the E&C industry self-destruct a couple of times during investment downturns.
    • The industry has seen distress-based consolidation as well as competitive bidding that has resulted in low or zero margins or project failures and over-runs that have caused even more financial distress.
  • There are participants in the global Power and Renewable space that have lower costs and, equally important, lower investment return expectations/tolerance than GE. The risk that GE loses both on the new equipment side and on the Power maintenance side remains high.
    • The margins that we see in the businesses today may not be the bottom and consequently we find it hard to get behind the stock – even at these lower values.

Exhibit 1

Source: Capital IQ and SSR Analysis

Details

Earlier in the year we suggested that we might be interested in GE below $12 per share – something the company achieved (for a short while) last week. We note that the analyst that has been most bearish on GE – and most correct – has stepped down his target price as the stock has declined and in situations like this it is important to establish whether you are moving your target price to stick with a story that is working or because you have new information.

Last week we touched on one of the problems of chasing a stock up – which is the eventual overestimation of earnings leading to negative surprises. Sell recommendations are far less common, but the same logic can apply. Rather than take our target price down for GE we are going to lay out a logic for the stock to move below $10 per share. For this to happen we would need to see further earnings degradation and another step down in estimates – probably below $0.75 per share for 2019. This is not unlikely on a reported basis – in fact we believe that reported earnings could be close to zero over the next 18 months – but GE’s businesses would need to get much worse for this to happen on a recurring basis.

First, the reported numbers. We expect GE to take some substantial write downs over the next 18 months as well as further restructuring charges. This based on the assumptions below:

    • Goodwill is too high – Exhibit 2
    • Has risen dramatically as a portion of overall capital – Exhibit 3
    • In part because capital has fallen – Exhibit 4
    • And despite the falling capital – returns have not improved – Exhibit 5

We do not see, given results (in both the power and energy businesses) how the Goodwill associated with either can pass any normal impairment tests. It is unclear why we have not seen impairment charges already – which leads to a broader concern, and one related to recurring earnings, that GE still does not have its hands around its finances and its accounting practices.

Given the well documented problems in the power business as well as lower business activity in renewables, we expect further headcount cuts and restructuring charges in both businesses as well as charges associated with both the Transport divestment and the Healthcare separation.

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

Source: Capital IQ and SSR Analysis

Recurring Issues

On the recurring side of earnings, for things to get much worse at the stock price level we would likely have to see another step down in earnings in the Power and/or the Renewables segment. While Energy could disappoint, it would likely be largely ignored in valuation because the company has elected to separate the business – Aviation is fairly stable and while the Capital segment is a wild card, but is generally looked at as non-recurring, and while it has the risk of driving significant cash charges – as does the pension plan, unless it called into question balance sheet solvency of the company it is unlikely that further manageable charges would take the stock much lower. The rest of the segments are summarized in Exhibits 6.

Exhibit 6 Source: Capital IQ and SSR Analysis

As Exhibit 1 shows, margins in both Power and Renewables appear to have stabilized – albeit at low levels and against much reduced revenues in both segments.

Our concern for recurring earnings in these segments is driven by the decline in revenues in Power and Renewables – Exhibit 7 – and the possible impact on market dynamics:

    • The revenue issues are not just GE issues and every participant in the power and wind industries are experiencing reduced demand and underutilized capacity.
    • Companies behave in their own perceived best interest when in downturns and this is more than likely to lead to price pressure, not only on new plant and equipment but also on maintenance as every player looks at market share gain opportunities to offset slower overall demand.
      • Almost every industry has seen dynamics like this – no reason why it should not happen here also.
    • In the wind space there is also pressure from the customer – with limited subsidies and more competitive global natural gas prices, wind farm operators need to lower capital costs to be competitive and it is not a stretch to see a scenario where suppliers cut prices to win volume.
      • In these situations, the companies with less regard for metrics like return on capital and a more aggressive market share mindset will likely make headway at the expense of GE – or could drag GE pricing lower as maintenance contracts come up for renewal.
    • The maintenance side of the power business is similarly at risk in our view, but more because of competition than because customers have a competitive need to lower costs in the way that wind (and solar) based generation does.

Exhibit 7

Source: Capital IQ and SSR Analysis

The Ethylene Example

It may not seem that obvious to compare ethylene – a basic chemical – with power generation equipment but bear with us! Very strong growth in demand for polyethylene, polyester, and polystyrene drove substantial investment in ethylene through the late 1970s. When the OPEC oil price hikes had created major developed world inflation a recession, demand growth for ethylene fell, initially and then grew slowly creating 25-30% overcapacity in the market. In power today, we have more than 50% overcapacity based on most of the analysis and company comments that we have seen – and we have the slower (negative) growth because of efficiency gains and gains from solar and wind power. Sounds worse than ethylene was in 1981/82. Exhibit 8 shows how US ethylene margins behaved from 1981 through 1989. An initial decline – some stability and even an improving trend but ultimately followed by a sharp decline caused by a market share battle, ironically just before the global market turned to shortage.

We think this risk exists in both power and wind today: no-one is expecting a quick recovery in demand for power equipment and cheap natural gas is keeping the pressure on wind investments. We are concerned that what we see in Exhibit 1 is the consequence of lower revenues caused by lower demand. We are unconvinced that the gloves have come off yet on pricing – but we think it is likely that they will.

Exhibit 8

Source:

In Exhibit 9 we show stock valuation data for the only company with the relevant history: Dow Chemical and we have taken a snapshot from our normal value analysis that for Dow runs from 1970 to today – consequently you see a chart that is imbalanced – more expensive than cheap. However, the chart shows two periods of underperformance relative to the S&P – the first one when the market for ethylene first deteriorated – 1981 through 1983 – followed by a short rally – followed by a second period of underperformance as margins collapsed a second time because of attempts to gain share. One standard deviation in relative value for Dow was around 20% – so the first decline was underperformance of 65% and the second around 25% – we think the risk is that GE may have seen the first leg down with the second yet to come – especially without the cash flow cushions and dilution from Healthcare and Energy.

Exhibit 9

Source: Capital IQ and SSR Analysis

Can GE also lose pricing in its maintenance business?

GE talks about how much of its power business is maintenance of the installed base and this is generally thought of as stable and protected. However, service businesses can also come under attack, especially if competitors have mouths to feed. While the E&C business is not a direct competitor, it is an adjacent proxy. There is limited data before 2000 as few companies in the space were public in their current form. This is an extremely competitive business, and companies will sell their first born to win contracts resulting in the very low margins that are shown in Exhibit 10. Note that since 2002, this sector has not seen a net income margin approaching the current margin at GE. GE has both existing and new competition in the maintenance space and much of the new competition is in the regions that still have growth prospects for power.

Exhibit 10

Source: Capital IQ and SSR Analysis

This is all very hard to quantify, but further cuts in revenues and/or margins in both the renewable and power businesses are what it would take to drive GE towards $10 per share in our view – barring something unforeseen and calamitous in GE Capital. The scenario we outline above has a much greater than zero chance of taking place – maybe as high as 40-50% and consequently we still cannot see a reason to own GE. Note that each time we have made this call in the last year or so we have done so with the concern that we were perhaps missing the bottom, and so far each time we have been correct. This is a business where no-one “batts a thousand” and we are clearly getting closer to a bottom – probably not there yet.

©2018, 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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