As a buy and hold investor, it is anathema to me to sell a stock. I devote a great deal of due diligence before committing to an investment, and history teaches that quality companies are like Mark Twain: the reports of their deaths are greatly exaggerated.
I’ve witnessed supposedly moribund firms rise from the ashes. Therefore, it was with a degree of trepidation that I provided my first and only sell article in May. That piece focused on General Electric (GE), and since then the stock is a shadow image of the larger market.
By that I mean that the shares have fallen roughly 12% while the S&P rose around 12%.
The picture for investors has not improved, and my investigations uncovered additional reasons for concern. The UK unleashed a government agency intent on billing the company for $1 billion. Forecasts for airline traffic have deteriorated and provide a picture of a prolonged U shaped recovery, while governments around the globe prohibit travel, and economies worldwide spiral downward.
Two of the company’s businesses bring in little in terms of profits.
Here is an example of what passes for good news from a GE perspective: GE only experienced $2.1 billion in negative free cash flow last quarter.
Q2 Results… YIKES!
Just when some thought things couldn’t get worse, GE reported a Q2 loss of $0.26 per share. The company’s adjusted loss per share, which accounts for one-time items, hit -$0.15 versus a $0.16 profit in Q2 2019.
GE’s overall revenues declined 24% YoY with industrial revenue falling 20% on an organic basis. Even with a $600 million tailwind from the sales of ventilators and other COVID-19 related products, GE Healthcare suffered revenue declines. Total orders for the firm declined 38 percent.
Clearly this was a tough quarter. … the macro environment could deteriorate further before recovering.”
CEO Larry Culp, Q2 earnings conference call
As I stated previously, the good news was that the company had $2.1 billion in negative cash flow versus a previously projected negative $3.5 billion to $4.5 billion.
The worst of the lot was that the creme de la creme of the company’s segments, aviation, suffered a 44% drop in revenue YoY.
Why Much Hinges On The Aviation Segment
The two charts below speak volumes regarding the importance of the aviation segment to GE’s overall results.
Source: Metrics GE reports/ Chart by Author
Aviation contributes less than a quarter of the overall revenues for GE. Were that the whole story, the company would be in significantly better shape. Unfortunately for investors, there is more to this narrative than meets the eye.
As is noted below, revenues are one thing, profits another. The renewable energy business contributed nothing while aviation provided nearly two-thirds of the company’s profits last fiscal year. Healthcare provided all but 4% of the remaining profits for GE.
Source: Metrics GE reports/ Chart by Author
Consequently, to gauge the future for GE, we must weigh the prospects for the aviation business.
An Aviation Apocalypse
The International Air Transport Association (IATA) projects the aviation industry will lose $84.3 billion in 2020. IATA also predicts airlines will lose $37.54 per passenger while the percentage of seats filled by passengers will decline to an average of 62.7% of capacity. This compares to an average of 82.5% in 2019. It should be noted airlines require an average of 70% of capacity per flight to break even when fully operational.
IATA forecasts revenue passenger kilometers (RPKs) will not reach pre-pandemic levels until 2024. As of last June, RPKs had fallen 86.5% YoY. Their estimate that global airlines require $200 billion in assistance from their respective governments is a measure of the financial stress prevailing throughout the aviation industry and indicates demand for new aircraft should remain muted for the short to mid term.
We foresee reduction in maintenance, repair and overhaul demand of 60% or more for commercial aero engines (in 2020). And production will fall 40-50%.
Kevin Michaels, managing director AeroDynamic Advisory
There was a brief rally in demand, but in the last week of August, airlines planned global capacity dropped by 600,000 seats.
Chart: Scheduled Airline Capacity by Week Compared to Schedules Filed on 20th January 2020 & Previous Year
TSA checkpoint numbers are improving, but even on the best days total traveler throughput numbers are well below 50% of last year’s tallies. In fact, it is common to see checkpoint numbers of roughly a quarter to a third of 2019 totals.
According to IATA, even cargo traffic is down by 18% this year. In mid August, IATA lowered the airline demand forecast from previous estimates. It is now projected that demand will be 30% to 40% below 2019 levels, with a return to prior capacity in 2024.
Meanwhile, the PEW Research Center estimates 93% of the world’s population lives in countries with restrictions on tourism and business travel.
One of the consequences of this environment is that aviation suppliers will likely experience a 75% decline in service revenues this year amounting to $60 billion in sales.
MRO spend also translates at some point to new aircraft orders.
This is going to be a very brutal time for companies dependent upon aftermarket revenues. The job cuts and spending cuts have only begun.
Richard Aboulafia, analyst aerospace consultancy Teal Group.
If investors expect GE’s aviation segment to resurrect the company’s fortunes, they need to consider the company’s announcement regarding the jet-engine unit last May. That division suffered 13,000 job cuts, amounting to 25% of the workforce.
Those numbers alone speak volumes.
The Taxman Cometh
Her Majesty’s Revenue and Customs (HRMC) raised a suit charging GE with “fraudulent misrepresentation”, to the tune of $1 billion. HRMC claims GE engaged in a tax avoidance scheme related to proposed business investments in Australia. HRMC alleges GE engaged in a complex and contrived tax avoidance scheme.
The sum of $1 billion does not include interest and penalties.
I’ve read analysts that opine the $1 billion is of no consequence. Count me among those that believe a billion here and a billion there amount to real money.
The Millstone Around GE’s Neck
I’ve repeatedly warned readers of the liability lurking in the company’s long-term care business. Nonetheless, investors were “shocked” in 2018 when management revealed a $6.2 billion after-tax charge and revealed plans to devote $15 billion over seven years to cover claims for long-term care policies.
Last year, the company shoveled some money into that deep, dark hole. While the sums provided meet or exceed those of most other long-term care policy providers, there is a catch that could render these efforts null. The current sums are equivalent to $55,000 per policy. That pales in relationship to the average cost of a one year stay in a private nursing home room ($92,376).
I think it is impossible to know whether the $15 billion is enough.
Joseph Belth, professor emeritus of insurance at Indiana University
A number of analysts see GE’s moves as too little, too late (other insurers raised premiums as long-term care proved risky) and estimate the company will require an additional $12 billion to cover projected costs.
Another concern is GE’s pension program. The firm’s pension liability stood at $92 billion as of the middle of 2019, and was underfunded by $22 billion. The company made some headway since that date with plans to add $4 billion to $5 billion in funding.
I’m Not The Only One Warning Investors
Last April, JP Morgan analyst Steve Tusa characterized GE as the “most expensive value trap we’ve ever seen” after cutting the company’s target price from $7 to $5.
Despite the cash burn we expect in 2020, our lower rating is ultimately due to a highly uncertain outlook for GE’s balance sheet and earning power in 2021 and beyond.
Colin Scarola, CFRA analyst
Also in April, analysts for UBS and Citigroup cut their price targets from $12 to $9 and $11 to $9, respectively.
In August, Tusa withdrew his price target on the stock altogether, simply stating that fair value for the stock is likely below $5.
Then there’s one of those “read between the lines” kinda warnings. Trian Fund, a long time investor in GE, sold huge chunks of its position in the company in last July and early August.
Another sign that GE’s hopes are diminishing: General Electric’s board revised the terms under which Larry Culp can receive a near quarter billion reward for reviving the company. Previously, Culp had to drive the stock to $31. His contract was revised to reward him with the same sum should he push the share price to $16.68 within a few years.
Dividend, Valuation, And Debt
With a yield of around .6%, the dividend is a token designed to allow institutional investors to keep the company as a dividend bearing stock. Consequently, it will remain but at the cost of draining GE of badly needed funds. Despite the paltry payout, with 8.75 billion shares, 4 cents per year amounts to $350 million in outlays.
As I write these words, the stock trades for $6.42 per share. The average 12 month price target of 15 analysts is $9.13. Two of the three analysts covering the stock failed to provide a price target after the last quarterly report. The third has a price target of $6.25.
GE’s debt to equity ratio stood at 2.4 times at the end of the Q2. In comparison, rivals Honeywell (HON) and Emerson Electric (EMR) are 1.2 and 1.0, respectively. When adjusted for the finance arm, GE’s debt is a more palatable 1.4 times.
In April, S&P cut GE’s credit outlook to negative. This means there is real risk that the company, which is currently rated BBB+, could suffer a downgrade.
Borrowing from some of Dividend Sensei’s work, we learn this would increase GE’s odds of bankruptcy to 7.5% over a 30 year period. It would also move the company’s credit to just two notches above junk status.
Can you make money buying GE stock at the current level?
A year from now, I wouldn’t be surprised to learn that a shareholder buying the stock today doubles his or her money.
The problem is, I also wouldn’t be astonished to learn that the stock dropped to half its current value in a year.
The shares in any company can swing up or down in a manner that defies reason. Investors shouldn’t be concerned with the possibilities, but rather with the probabilities. We need to think like Mr. Spock, not Doctor McCoy.
A few concerns to reiterate along with additional considerations: GE has $72 billion in long-term debt as opposed to a market cap of $56 billion. The aforementioned Steve Tusa estimates the company’s enterprise value at $65 billion, based on competitors valuations.
GE burned through $4.3 billion in cash during the first half of FY 2020. Analysts project a loss of 8 cents per share in the coming quarter versus EPS of 15 in Q3 2019, while revenues are anticipated to drop by 19%.
The aviation business, by all accounts, will take years to recover.
With the above in mind, I reluctantly reiterate my Sell rating on GE.
One Last Word
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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: I have no formal training in investing. All articles are my personal perspective on a given prospective investment and should not be considered as investment advice. Due diligence should be exercised, and readers should engage in additional research and analysis before making their own investment decision. All relevant risks are not covered in this article. Readers should consider their own unique investment profile and consider seeking advice from an investment professional before making an investment decision.
Originally published on Seeking Alpha