Holding GE over the last few months, there have been plenty of reasons not to be overjoyed when the firm makes a new announcement. Last week, the firm announced that it would restate the last three years of earnings due to an accounting change related to revenue recognition for complex, long-lasting projects. The stock fell on the news, but recovered later in the day.
The details are a bit tedious, and are covered below. The main take-aways are as follows:
- The accounting change — ASU 2014-09 — does not affect cash flows.
- GE was not singled out or found to be cutting corners with its accounting — it was accounting for long-term contracts appropriately under US generally-accepted accounting principles (GAAP).
- The rules change was orchestrated by an agreement between the US Financial Accounting Standards Board (FASB) and its European counterpart to remove ambiguities in respective accounting systems and to make the two systems more directly comparable.
- Essentially, the change means that when new service work is contracted by a current service customer, the add-on contract is booked as new one, rather than tacked on to the original contract. Nothing changes about the economics of the transactions, just how it is represented on the firm’s books.
- While speaking with management, I got a much clearer picture of how GE’s service contracts are structured.
Because the final point is the most important in terms of valuation, I’ll lead with that and cover the accounting change last.
GE’s Service Business
When GE sells a new gas turbine or aircraft engine, the equipment has a warranty period — let’s say 24 months long — during which GE engineers will service the equipment as part of the purchase price. The customer can also purchase a service agreement that will pick up after the warranty period ends. Because many of the products GE sells are long-lived equipment, service revenue makes up a larger proportion of total revenue than equipment.
Service agreements are structured such that GE is paid for every hour the equipment is operating normally. If the equipment is not operating to some specified utilization level, GE technicians will repair it. In addition, service contracts specify that GE will perform scheduled maintenance on a piece of equipment after a certain number of hours in service.
In addition, a company can buy a piece of equipment from GE, but elect not to buy a service package. In this case, GE sales will follow up with customers at regular intervals to try to win any necessary service work.
As equipment ages and the service agreement winds down, even though the turbine / engine may function fine, technological advances mean that it the equipment is no longer as efficient as newer models. Engineers performing service work can suggest the customer buy a newer model or might suggest a refurbishing service that will increase the old equipment’s efficiency (this is not, as far as I know, done for aircraft engines, but is done for gas turbines, where the product / service combination is known as Advanced Gas Path or AGP). This upsale cycle is a good way for GE to earn new business and continue a business relationship with its current clients. It’s always cheaper to keep a client than it is to find a new one.
Figure 1. A GE gas turbine destined for a gas generation power plant.
In the third and fourth quarter conference calls, GE management has talked about a short-fall in Power service revenues due to fewer “service outages.” This has come about due to two factors:
- An increased reliance on alternative power generation that reduces utilities’ need to produce “peaking” power using relatively inefficient gas turbines.
- Organizational fumbles post-Alstom merger that meant that it lost non-contract service business to competitors in Europe.
The second point is straight-forward: organizational reshuffles meant that GE / Alstom staff missed the opportunity to win service business from customers that did not have a service contract. GE says that it is putting its house in order on this count.
Regarding the first point, utilities do not run at maximum capacity all the time. Usually, generation plants have spare capacity, so when the summer gets hot or the winter cold, it can generate a bit of extra power to run more air conditioners and heaters. On the hottest and coldest days, though, demand for power exceeds the plant’s normal capacity. At these times, utilities rely on “peaking” generators — older generators that might be less efficient, but which can provide a little extra juice when called upon.
As more wind and solar power installations are built out, some of the “base load” power requirements are taken care of that way, allowing gas generation plants to have even more capacity. Because of this, peaking generators are not as necessary; alternatives carry more of the base load, so the main turbines can generate power for the peak load.
Because peaking generators are now less heavily used, GE’s per-hour service revenues have fallen somewhat. In addition, because the peaking generators tend to be older, less efficient ones, the fact that they are not being used as much means that the standard service thresholds are not reached as quickly. This also cuts down on Power service revenue.
Understanding this dynamic, I am getting a better picture of the degree to which alternative power generation sources are impacting GE’s power business. I will incorporate this understanding into my new model.
Earnings Restatement
GE provides long-term service contracts in all segments, but the largest and most important service businesses are Power and Aviation.
GE’s service contracts are set up such that the client pays a certain amount per year and GE contracts to provide the customer with service sufficient to maintain the equipment at a specified utilization level as explained above. The contracts are multi-year, whereas customer payments are annual.
GE’s multi-year service contracts tend to be “front-loaded” meaning that GE must spend more time adjusting equipment early in its life than later. This means that GE sometimes performs more services early on — its gross profit margin is lower at the start of a contract than at the end.
Long-term service contracts must follow the accounting principle known as “matching,” which means that costs must be recorded when the service is performed, no matter when cash is received.
If costs are recorded before cash is received, the firm is allowed to book revenues that match with the costs. Because this revenue is not associated with a cash inflow, the firm books an asset called “Revenues in Excess of Billing.” Essentially, the firm providing the service work has accepted an IOU in lieu of cash for services performed. GE calls these IOUs, plus other items associated with the service work “Contract Assets.” The following table shows a list of GE’s contract assets at the end of 2017.
Figure 2. GE’s 2017 Annual Statement (10-K)
Recognizing revenue in this way conformed to US GAAP until FASB made a rule change in 2014. This rule change was scheduled to go into effect for full fiscal years reported after December 15, 2017. The first fiscal year following that date that GE will report is its fiscal year 2018, which started on January 1 of this year.
The FASB worked with the European standards board (which makes rules determining the International Financial Reporting Standard – IFRS) to correct for ambiguities in the way long-term service contracts were booked under both IFRS and US GAAP and to put both standards on a more common, comparable footing.
There are two main outcomes from the rule change:
- If excess costs are incurred, the matching revenue will have to be recognized more slowly — over the entire life of the contract — rather than in the period during which the costs were accrued.
- If new services are sold to the customer, those services will be treated as a wholly new contract, rather than as an addition to the first. As such, revenues will be recognized more slowly.
Both of these outcomes only affect bean counters in the back office and the IT support personnel that must write software to change the calculations to conform with the rule change.
Whenever a rule change is made, prior period restatements must be done for all years reported. As such, starting this year, GE will use the new revenue recognition rules for fiscal year 2018 and will restate earnings for 2017 and 2016 — the other two years during the reporting period.
The cash that GE earned from its operations over the 2016-2017 period was pathetic, but it will not change because of this rule change.
In a phrase, the early market reaction on the day the restatement was announced is much ado over nothing.