Fitch Downgrade Signals Pain Ahead For GE

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General Electric (GE) missed on Q3 earnings and the stock is off over 20% since. Things might have gotten worse after Fitch downgraded the industrial giant:

Fitch Ratings has downgraded the Long- and Short-Term Issuer Default Ratings (IDRs) for General Electric Company (GE) and GE Capital Global Holdings, LLC (GE Capital) to ‘A+’ and ‘F1’ from ‘AA-‘ and ‘F1+’. The Rating Outlook is Negative … The downgrade of GE’s ratings considers the deterioration in the company’s operating and financial performance including a slower return to higher margins and stronger free cash flow than previously anticipated by Fitch. GE’s performance is being affected by secular changes in the Power segment’s gas turbine business that has reduced long term prospects for growth.

The downgrade follows a Moody’s downgrade weeks earlier. It could also signal more pain ahead for GE.

Power’s Demise Could Be Structural

A major task for management is to fix the issues related to Power Systems. Revenue from the unit was down 4% Y/Y and orders were off by over 15%. Power is undergoing structural changes and apparently GE has not reacted quickly enough. The market for heavy duty gas turbines declined to 40 gigawatt from 46 gigawatt, which apparently caught the company unawares. Too much equipment and/or inventory geared towards a segment in decline might have hurt working capital as well.

The growth of wind and solar power are beginning the disrupt the traditional business models of more established power companies, including GE. Fitch also alluded to the fact that there could be excess capacity within the segment. That excess capacity could be exacerbated by the encroachment of renewable energy. Secondly, it could also make cost outs for Power less effective. I originally assumed cost outs would improve margins. If revenue falls due to a shift to 40 gigawatt gas turbines, or continued encroachment of renewable energy then the company would likely have to cut costs simply to sustain margins.

GE also has a Renewable Energy segment which could benefit from continued use of renewable energy. It had Q3 revenue of $2.9 billion and segment profit margins of 9% – paltry by GE’s standards. Though Power’s margins were 7% during the quarter, they were 14% in the year earlier period. I envision a few scenarios. Either (1) Power’s revenue and margins decline or (2) its sales are cannibalized by the Renewable Energy segment which has lower margins long-term. I think that should give Fitch and GE bulls cause for concern.

Reduction In Free Cash Flow

During GE’s recent investor day management admitted its dividend pay out of $0.96 per share ($8.4 billion) exceeded the company’s free cash flow. It confirmed to me that in many ways GE’s core earnings and cash flows remain opaque. GE cut the dividend in half, yet its ongoing free cash flow remains a concern.

In Q3 2017 GE generated cash flows from operations of $465 million. That is paltry compared to the $7.6 billion it generated in year earlier period. The major difference is that the parent compared received dividends of $5.1 billion from GE Capital in Q3 2016. GE Capital did not upstream dividends in Q3 2017. Management is currently performing an actuarial analysis of claims reserves pursuant to its insurance business. Dividend upstreams from GE Capital to the parent company is expected to be deferred until such a review is completed. For the near term the parent company’s free cash flow and dividend paying ability could remain challenged.

Increased Borrowing Costs

The ironic part about the downgrade was that GE was previously known for its pristine AAA credit rating and its extremely low cost of capital. The Fitch downgrade could now increase GE’s cost of capital. The company has $136 billion in debt, of which $28 billion is short-term. About $18 billion of short-term debt is commercial paper and another $10 billion is in the form of inter-company loans. Pursuant to the $18 billion in arms-length short-term debt, for every 100 basis point increase in interest rates GE would incur an additional $180 million in interest expense.

Rising borrowing costs could further crimp GE’s free cash flow regardless of what management does. If management does not quickly come to a landing on the company’s strategic direction then then further downgrades could lie ahead.

Conclusion

I believe more pain lies ahead for GE. Sell the stock.

On Trump And The Global Economy

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