My focus has never been on large caps, and I don’t cover General Electric (GE) often. When I have, I’ve tried to warn here several times (twice in 2017 here and here) on Seeking Alpha as I have been a fundamental bear for some time. Every time I think the valuation is starting to remotely come into line, another shoe drops that has me questioning the entire corporate structure again. I often get questions about buying the company since I run an Industrials-focused Marketplace offering (Industrial Insights), especially at today’s valuations. In my view, very little has changed of my opinion here in the wake of all the analyst downgrades and the poor outlook for GE Capital driven by the upcoming $6,200M after-tax charge on the way in Q4. I still don’t see a valid reason to pull the trigger. What I spoke to last time I covered the firm heading into the Investor Day rings just as true today:
This isn’t meant as a victory lap on a correct call, but just another cautionary tale of why owning a company with eight operating segments, a plethora of intercompany transactions, hazy non-GAAP metrics, and a steep valuation can often be a time bomb sitting in your portfolio.
While I think retail investors often get themselves into silly situations, Keep It Simple Stupid (“KISS”) is always one of the best approaches smaller investors can take. While investors need to be educated on the companies they own or would like to own, not everyone can be expected to have either the experience or qualifications to make sense of complicated financial statements. With relatively easy to understand companies – 3M Company (MMM), Apple (AAPL), etc. – shareholders don’t need to concern themselves with the tiniest of details. Arguably, Joe Schmo might have his ear to the ground on trends in product demand better than someone sitting on 200th West Street in Manhattan at his office at Goldman Sachs (NYSE:GS). These companies make products consumers want, demand is healthy, and financials are reported in a clean, easy to understand way. GAAP results closely mirror non-GAAP, cash flows are healthy, and results have been predictable. General Electric has never been that company. My hope was that the transition away from GE Capital would eliminate that to some extent, but until that is wound down completely, the long-term care issues within GE Capital might not be the last bombshell.
Insurance Charge Implications, Rough Start To Flannery’s Tenure
Most investors are now familiar with the upcoming insurance charge, under which General Electric will bear a $6,200M after-tax charge in Q4 (along with $2,000M/year for the foreseeable future) as it increases statutory reserves by $15,000M. As a result, GE Capital will suspend dividends to General Electric, and this likely means that GE Capital Aviation Services (“GECAS”), which I had hoped would be sold off to raise funds, will need to be retained to help shore up finances. Remember, shareholders were promised a clean separation from the entity alongside a return to industrial roots. How likely does that look now?
This charge relates to the legacy insurance business that was spun off into Genworth Financial (NYSE:GNW) in 2004/2005. As one of Jeff Immelt’s early moves as CEO, these long-term care liabilities have always been known to be a potential problem. In fact, General Electric reportedly held on to these liabilities in order to not depress Genworth’s initial public offering (“IPO”) valuation. Still, when you have Moody’s insurance analysts making statements like these alongside credit downgrades (GE Capital standalone credit was downgraded to Baa3 from Baa2 recently):
…the risks associated with GE Capital’s insurance activities are considerably greater than we previously thought…
That indicates a deep structural problem in clarity of operations, and calls into question how this problem could go unnoticed for so long. It also brings into question the potential fall-out for other insurers that had or have exposure to the long-term care insurance industry, including MetLife (NYSE:MET), Prudential Financial (NYSE:PRU), Unum Group (NYSE:UNM), and CNO Financial (NYSE:CNO). Coming from an internal audit background, this is deeply troubling as it relates to internal risk assessment, as well as how well KPMG performs its job as auditor. Unfortunately, it might not even be the end of the story within long-term care. Given the elevated claims and high performance volatility and leverage here, GE Capital might need even more capital support in the future. Pain here might not be over.
You can’t fault Flannery for any of this. These issues did not occur under his watch, and he said every stone was going to be turned late last year. It is clear that he continues to take those steps. Shareholders, either current or prospective, need the certainty that the company has been gone over completely. If that involves (hopefully) short-term pain in the common stock price, so be it. Corporate culture at large enterprises like General Electric is inevitably an issue as the nuances of day-to-day operations get lost as information is moved up the management chain, and it takes a very hard-line stance from management that propagates from the top down to reverse years of mismanagement. This won’t be an easy fix; it will take time to right-size the portfolio and get the General Electric ship turned on a proper course.
When To Buy?
This translates over to when to buy. Patience is a virtue. I’m guilty of mistiming an entry as much as anyone, but what I’ve found is that is very rare for entry opportunities to be short-lived. There is rarely a case where I need to buy right now, today, or even this week. Market sentiment is notoriously hard to turn, and the buy calls all the way down on Seeking Alpha were plain as day signs that there had been no capitulation. The company isn’t out of the woods yet, as problems persist. Already known, the pension shortfall continues to be a clear headwind that will need to be closed eventually.
The opportunity will come when operational results turn. Given the company’s massive interest expense and historically poor cash flow figures in 2016 and 2017, investors do need to take stock of interest coverage if results continue to languish. What was previously viewed as an ironclad balance sheet is showing substantial kinks as General Electric burns through billions of dollars, and the more than $21,000M spent on buybacks in 2016 now should give shareholders palpitations. Waiting for a turnaround never hurt anyone. In my view, paying a possible premium to today’s share prices six months to a year down the line in order to ensure operations have returned to health and results are more clearly presented is a far better alternative to buying today.
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Disclosure: I am/we are long AAPL.
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.