General Electric Co. optimists just got their latest reality check.
Shares of GE slumped more than 8 percent on Monday after JPMorgan Chase & Co. analyst Steve Tusa laid out a case for why cash flow at the embattled conglomerate will remain depressed for the foreseeable future and advised investors to reduce their exposure to the stock. That pushed GE back below $10, erasing a March rally fueled by management promises of a meaningful recovery in free cash flow in 2020 and 2021. Investors bought into that optimism despite any clarity around what in fact meaningful actually meant and little in the way of actual numbers to back up that idea amid ongoing efforts to stabilize the power unit and unwind GE Capital financing programs.
This see-saw has occurred multiple times over the course of GE’s lurching recovery, and the pattern is always similar. The March rally followed a plunge at the beginning of the month when CEO Larry Culp sat down with Tusa at a JPMorgan conference and acknowledged the company’s industrial businesses would burn cash this year. The decline on that news was the steepest since Oct. 30, when GE reported a $630 million operating loss in its power unit, causing Tusa to question if the business was salvageable. That drop had erased a substance-light spike in the shares after Culp’s Oct. 1 appointment to the CEO post as investors ignored the fact that GE had taken a $22 billion writedown in its power business and put their faith in him as the company’s savior. I could go on, but you get the point.
I understand the bias toward hopefulness: GE is a corporate icon, a symbol of American might, an employer of thousands of people. It seems too important not to succeed in rehabilitating itself, so investors are positioning themselves to catch the falling knife and ride the rebound. The problem is, they are breaking classic investing rules in an attempt to do so and seemingly failing to learn some of the lessons of GE’s past.
Let’s start with cash flow. While the company says some of the factors driving its expected industrial cash burn of as much as $2 billion this year won’t repeat, it still anticipates negative cash flow at the power and renewable energy units in 2020. Cash flow at the health-care unit is expected to be up in 2020 but not enough to compensate for the $1 billion GE is estimated to lose from the sale of its biopharmaceutical business to Danaher Corp. In turn, Tusa points out that his fellow analysts have been trimming their free cash flow targets for 2020. But he says some are still clinging to robust 2021 expectations of $8 billion to $9 billion in free cash. While none of GE’s peers get the benefit of being valued on 2021 numbers, if you think that’s the trajectory this company is on, then the rise in the stock the past few weeks is appropriate.
But to believe in that kind of drastic cash swing, you have to:
1) take GE at its word that the aviation unit generated $4.2 billion in free cash flow last year and will continue to post something in that range,
2) believe that the power unit will recover sharply, and
3) agree with CFO Jamie Miller that the company’s businesses will be resilient in a recession.
As I flagged last week, some investors have questions about how GE arrived at the cash flow numbers for its individual units. It has a fair amount of discretion as far as how it allocates corporate overhead and intercompany transactions, and that can swing the numbers materially. Tusa points out that the $4.2 billion in aviation free cash flow is more than $1 billion higher than the target set for the purposes of calculating unit chief David Joyce’s 2018 bonus, even as earnings beat goals by less than $100 million. Some may think GE’s adjustments and allocations are justified; regardless, everyone should be asking these kinds of questions, given the company’s tendency to rely on a variety of puts and takes in its earnings numbers.
The assertion that GE can ride out a recession relatively unscathed doesn’t make a lot of sense to me. Miller pointed to the backlog in power to help support this notion, but that backlog is already shrinking and it seems likely that utilities could curtail already light order flow in the event of a downturn. Furthermore, GE is likely to face growing competition as Siemens AG expands its partnerships with Chinese companies and contemplates a merger of its large gas turbine business with Mitsubishi Heavy Industries Ltd. Culp, in an interview with Bloomberg TV’s David Westin, said he expected more of an L-shaped recovery for the power business.
Aviation also doesn’t seem bulletproof: The crisis around Boeing Co.’s 737 Max plane has given airlines – including those whose expansion plans were likely too aggressive – cover to cancel orders, suggesting backlogs may not be set in stone. A recession would also undermine GE’s ability to sell assets, while a decline in interest rates could balloon its pension funding requirements and insurance liabilities.
Investors keep trying to give GE the benefit of the doubt. But it’s exactly that kind of thinking that allowed the company’s problems to grow below the surface for so long. Optimism is a right this company hasn’t yet earned.