General Electric (GE) may suffer the consequences of adverse macro factors before its turnaround can come to fruition.
Shares of the Boston-based conglomerate have taken a nosedive in morning trading, dipping over 7% at daily lows, following a bearish report from JP Morgan analyst Stephen Tusa.
The drop in stock price has left shares back at the level after CEO Larry Culp called out cash flow issues for 2019 at the JP Morgan Aviation, Transportation & Industrials conference on March 6 before outlining a recovery strategy that reassured many investors.
"GE's challenges in 2019 are complex but clear. We are facing them head on as we execute on our strategic priorities to improve our financial position and strengthen our businesses," Culp said less than one month ago. "We have work to do in 2019, but we expect 2020 and 2021 performance to be significantly better with positive Industrial free cash flow as headwinds diminish and our operational improvements yield financial results."
While the rebound set by Culp still puts a true turnaround off for quite some time, it began to set a base case for those hoping to see GE recover in the longer term and regain some of the status that saw it headline almost every major portfolio in years gone by.
However, that turnaround story is being challenged Stephen Tusa, not only on its potentially overly optimistic outlook, but also on the basis of factors it ignores. Namely, a potential recession on the horizon.
"We see a real bear case in potential recession for a materially lower equity value than even our base cast PT implies, given high leverage, and mechanical math around entitlements," Tusa commented. "Given the significant move in the stock since December, the risk/reward has tilted back negative, and we are again Underweight."
Challenging Culp's turnaround schedule, Tusa pointed to discrepancies he sees in the GE Capital Services segment (GECS).
"The math at GECS is mechanical, and we disagree with management's assertion that it will be break-even in 2021 and find the comment around improvement in the same year in which it will take a "material" hit from GAAP insurance charges (likely $5+ billion) as simply not feasible," Tusa concluded. "We see run rate losses here of $1.5-2 billion, masked by gains and tax benefits, which, once the portfolio is wound down, should be less of a factor, and likely go to zero in the event of a recession. In other words, the core business eats into book value on a run rate."
The issues presented for the core business if the market moves downward are only exacerbated by GE's persistent pension problems that reached a fever pitch of $31 billion in unfunded liability in early 2018.
"We think burdens from entitlements (pension/insurance) that cover 1 million people are a real problem, a major risk that could potentially be a $30 billion-plus hit in a recession, and tangible reason why GE is not defensive as the CFO recently asserted," Tusa said.
He added that IPO'ing certain businesses, like healthcare, to get away from the pension overhang would do too much harm to the health of the core business that they become impracticable.
"Bulls appear to be overlooking the risk in a potential recession, where we see a legitimate case for a substantially lower equity value than $5 if they don't raise more cash, mostly on risk around entitlements, as a decline in asset values, along with the impact from a cut in rates would drive an increase in these liabilities of $30+ billion, almost 2x what the company just brought in from [GE BioPharma's sale to Danaher (DHR) ], making GE far from "defensive"," Tusa explained, "potentially IPOing the remainder of Healthcare could help, but would also remove the entire FCF of remainco GE."
Tusa explained that while the issues surrounding GE's liquidity are far from novel, the risk of recession would accelerate the problem to life-threatening levels.
"Putting discretionary insurance assumptions aside, in a recession scenario in which asset values go down significantly, and interest rates drop, we could see a material increase in this net liability," he concluded, noting this risk far outweighs the benefits garnered from the BioPharma sale. "We believe this is overlooked, but highlights the serious situation with materially higher than average risks at GE."
In his Tusa's view, the risk versus reward situation for the company has not changed much and the rally in share price has really been driven by hope and trust in Larry Culp, rather than what the hard figures reveal about the state of the company.
"Keep in mind that the above referenced our base case outlook, in a status quo economy," Tusa said, highlighting that his $5 price target could actually be optimistic on his own part. "With an eye on recession risk, we see a legitimate case for substantially lower equity value than even our base case if they don't raise more cash, mostly on risk from entitlements to 1 million people, making GE far from "defensive", and we still don't think investors appreciate the risk here."
To be sure, many economists believe that a recession may be avoided in the nearer term, buying Culp and investors that believe in his forecasts some time.
"That's a fundamental shift in the economy and the economic outlook, and it's not one that reaches its complete fruition after one year," White House chief economist Kevin Hassett said in mid-March. "The idea we would have a recession next year - it's certainly not impossible, recessions very often happen and few people see them coming - but it would be very unusual for such a thing to happen given the massive amount of capital spending and new capacity that's being brought online."
Still, when the free cash flow problems confronting the company are not set to full reverse until 2021, Culp could well be racing against the clock.