General Electric (NYSE:GE) was once an industrial icon, lauded for its business prowess. And then the deep 2007 to 2009 recession took the tide out and, to paraphrase investing legend Warren Buffett, showed that the company wasn’t wearing swim trunks. GE hasn’t been the same since, as its distressed finance arm forced years of asset sales, restructuring charges, and dividend cuts. All that effort, and three CEOs later, the company finally appears to have gotten the balance sheet into more manageable shape. But that’s just the first step in returning GE to its former glory…
Selling the crown jewels
The big news for GE today is that it is working hard to reduce debt and, finally, starting to see material progress. That’s included selling off a number of business, slowly liquidating its investment in Baker Hughes, and most recently selling a portion of its healthcare business — one of the company’s most profitable business divisions. That last one is big, however, as it should allow GE to cut leverage by as much as $20 billion in one move.
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In fact, over the next year, GE’s financial position should materially improve. That’s not to say it will have solved the leverage issue, since debt will still be high relative to peers, but management will have bought itself time. That doesn’t sound like a big win, but it is truly huge for GE and its shareholders. Where the company was once operating from a position that some have described as desperate, it can now take its time as it works to right the ship.
Which is great news, because GE still has a lot of work ahead of it. In fact, selling assets to raise cash might actually have been the easy part. Now that this process is, largely, over, investors will increasingly be paying attention to the hard work ahead.
More challenges ahead
The most obvious problems facing the industrial company’s operations today are the weak margins in its power and renewable energy divisions. These businesses serve the electricity sector, with the power division building things like the turbines that create electricity from steam and the renewable energy division producing things like wind turbines. Both lost money in the third quarter, coming in with nearly break-even segment profits.
That was actually an improvement for the power division, which cut its losses by roughly 80% year over year in the quarter. Results at renewable energy, meanwhile, were largely unchanged. Neither, at the end of the day, is in particularly great shape. To be fair, these divisions are operating in difficult markets, so some of the problem is out of GE’s control. However, together power and renewable energy make up roughly 40% of GE’s industrial revenues. It needs to right-size these divisions and get the businesses back into growth mode.
Then there’s the two divisions, aviation and healthcare, that are doing quite well. Segment profit margins at these two divisions were roughly 20% in the third quarter. Aviation’s profits were down a little year over year and healthcare’s were up a touch. From a big-picture perspective, these are strong results and at around 60% of GE’s industrial revenues, provide a solid foundation on which to fix its other two major divisions. But things aren’t necessarily great here, either.
For starters, GE had to sell a portion of its healthcare business to shore up its balance sheet. It was likely a necessary move, but one that will reduce the size of the division and, possibly, its long-term growth prospects. Aviation, meanwhile, has to deal with the fiasco unfolding at Boeing. GE is a key engine supplier for the grounded 737 Max jet. Although Boeing continues to work toward getting the airplane back in the air again, it is finding additional issues that need to be addressed before that can happen. The longer this process drags on, the greater the risk for GE. Put simply, GE has two businesses that it needs to turn around and two that it still needs to operate successfully — and all will require a great deal of effort and care. A healthier balance sheet helps, of course, but it doesn’t lessen the effort required.
And then there’s GE’s finance arm, which remains something of an unknown even after a decade of pain. GE has been working hard to reduce the size of this division, but it is still a big issue. For example, GE has around $33 billion in long-term debt that it attributes to the division and another $40 billion in insurance and annuity liabilities. Although this division’s adjusted continuing earnings were flat year over year in the third quarter, and just slightly positive, there’s so much bad history that investors should continue to consider it a material risk factor.
Next up is the not-so-minor fact that the SEC is investigating GE’s accounting practices. There’s no way to tell how this review will play out, but it’s never good when regulators get involved in a company’s accounting. It could lead to fines, sizable one-time charges, and material changes in the way GE handles its books — or it could amount to nothing. So, as with the finance division, the SEC investigation is a known unknown that increases uncertainty at GE.
Too many questions for conservative investors
Investors have to balance risk and reward when looking at a potential investment. GE remains roughly 60% below its 2016 highs and is vastly improving its financial foundation. That suggests that there could be material upside potential, since management will have more breathing room to get the business back on track. Because of all of the moving parts, it’s hard to put numbers on valuation here, but the company’s price to sales ratio is around 0.9 times today, notably below the roughly 1.6 times five-year average on this metric. That said, mending the balance sheet was just the first step. GE still faces material headwinds throughout the company that need to be dealt with. It remains a turnaround situation that’s only appropriate for aggressive investors. Conservative types should probably sit on the sidelines a bit longer.
