On 20 October I looked at the prospects for GE (GE) following the release of the third quarter results, in an article titled "Operational weakness adds to already large existing challenges". Weak third quarter results caused additional concerns about earnings power, leverage and the dividend, which subsequent has been halved in a move which I really like.
At $22 per share I called the risk reward not favourable yet despite the fact that shares have been underperforming a great deal already, as I had concerns about the earnings multiple as well as leverage. As shares have dropped another 20-25% ever since and management is taking the right actions, I am turning into a patient buyer at these levels.
Q3 Recap, What Is The Earnings Power?
GE posted third quarter earnings of $0.22 per share, that is an earnings number which looks relatively clean, coming in at $1.9 billion in actual dollar terms on the back of $33.5 billion in quarterly revenues. While this is a real GAAP number, it should be noted that earnings are favourably impacted by the fact that GE"s tax rate remains (in my eyes) unsustainably low.
The industrial business operated with a net debt load of $70 billion at the time, but this number excludes $37 billion in pension deficits. If we take this into account and add back another $10 billion in equity being freed up from the continued wind down of the financing business, realistic net debt stands at $97 billion in my eyes. Of course, much of the pension liabilities do not have similar strict ¨repayment¨ terms as regular debt has.
The industrial business posted operating profits of $2.5 billion which included $300 million in losses from the Capital business. Accounting for these losses, and adding back depreciation charges, EBITDA runs at $14 billion a year. With net debt of $97 billion leverage ratios are incredibly high at nearly 7 times. Not taking into account the ¨debt¨ from underfunded pension, leverage ratios are still very high at nearly 5 times. This results largely from the fact that third quarter results have been very weak, trending at less than $0.90 per share per annum.
As has been extensively discussed, the real pain comes from the fact that instead of posting earnings of $2 per share in 2018, earnings are now trending at just $1.05-$1.10 per share, a dramatic performance. That suggests that the third quarter has been weaker than the annualised full year guidance, which makes that full year EBITDA is seen at around $17 billion. If that number is more realistic, leverage ratios come in closer to 6 times if pension liabilities are included, or 4 times if we simply look at financial net debt. Either number remains quite high, especially as GE was handing out all of its earnings back to investors in the form of dividends.
Good Actions
On the back of the elevated leverage ratios and continued pressure on earnings, I advised GE to take real action to shore up its finances, as the company continues to see cash outflows in relation to pensions and restructuring efforts.
The good thing is that GE has cut the dividend in half, which was a much needed step. With earnings seen at $1.00-$1.07 per share, following the November update, earnings trend at $9 billion a year. Fortunately, the dividend payout has been cut in half to $4 billion, allowing GE to retain some of its declining earnings. The other good news is that the company is restructuring the power business by cutting some 12,000 jobs. This represents 18% of the workforce of the power business and 4% of the overall headcount in a move to save a billion a year.
GE is even contemplating selling other assets to raise cash. "Some" is an understatement, as the company set a target to reduce assets by $20 billion in the coming 12-24 months. This stands in sharp contrast to $34 billion in M&A pursued over the past four years.
Key for the company is to restructure the business and bring margins in line with its peers. On a current $125 billion revenue base, an industrial company should be able to post operating margins of 15%, as top performing industrial peers actually post margins of around 20%. Margins of 15% translates into potential operating profits of $18-$19 billion. Including $3-4 billion in interest expenses and assuming normalised taxes of 20%, earnings are seen around $12 billion, for earnings power of close to $1.40 per share.
That requires a great deal of work however and could warrant a $25 valuation if the market would be willing to apply a market multiple to such business. In that case EBITDA would jump towards $22 billion, which makes that leverage would be addressed in a significant way, mostly because of improved earnings power. This would be combined with retained earnings on the back of the reduced dividend payout as well as the sale of assets at reasonable prices.
Trading near the lows so far this year at levels around $17, most of the bad news appears to have been priced in after shares have already been cut in half, and management appears to have taken the right measures to address the situation. This includes a big dividend cut, cost cutting efforts and assets sales, as it really seems that the company has recognised its challenges and dire situation.
As a result I believe that the risk-reward situation has improved meaningfully as management"s awareness has increased and the stock has been moving lower, which makes that I am gradually start to buy into GE at these levels.
Disclosure: I am/we are long GE.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Acquired 25% of my ¨full¨ long position
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