Initial Impression of GE’s 3Q17 Earnings Call

We just finished listening to General Electric’s third quarter 2017 earnings call and, because it is a company about which we have written extensively over the last year, wanted to offer our initial thoughts on the report.

Executive Summary

• GE’s cash flow from operations, the measure which forms the basis of our Owners Cash Profit (OCP) metric was significantly below the level we expected and the level to which the firm had previously guided.
• The shortfall in cash flow was due to two segments in particular: Power and Oil & Gas. At least some of the dynamics related to this lower cash flow are related to contract timing and working capital issues that will be reversed next year.
• Other GE segments – Aviation, Healthcare, and Renewables, especially – performed well. We were surprised at how high Transportation’s margins were despite the moribund demand for US locomotives.
• The firm has generated less Owners’ Cash Profits than it has paid in dividends this year, a situation that is clearly unsustainable if the drop in OCP is structural.
• John Flannery, the new CEO, will make clear his intention for the dividend in the upcoming November meeting. We think the chance that the dividend payout will be maintained is better than even, but now, we do acknowledge the possibility of a dividend cut.
• Flannery plans to divest roughly $20 billion more of GE’s businesses over the next 1-2 years and is aggressively cutting costs in an attempt to maintain the present dividend.
• The JP Morgan analyst, Tusa, was clearly correct in his assessment of both near-term conditions in the Power business and in his comments about corporate culture.
• We were impressed by Flannery and Miller – the incoming CEO and CFO – and believe they are focused on the right things.
• We believe that our conceptual model for GE must change to incorporate a greater volatility in operational results. This volatility is due to cyclical exposure that had been obscured by the consistency of the firm’s erstwhile financial business.

We break out our comments into three sections: Cash Flow, Dividends, and Overall View.

Cash Flow

In our September update, we published the following projections for GE cash flows and OCP.

The Cash Flow from Operations for “2017 (I)” projection of $12 billion was originally provided as the lower end of the company’s guidance. This seemed a reasonable range based on our analysis of prior-year cash flow seasonality.

However, the guidance the firm provided today was around $7 billion for the year – 40% lower than our expectations. To make matters worse, the firm is reviewing insurance contract liabilities on the Financing side of the business that may also lower cash flow from that segment. Depending on what the numbers end up being, this will push 2017 OCP margin into the mid-single digit range, similar to the firm’s “one-off” poor margins of 2016.

The firm does not publish a full set of financial statements until several weeks after its earning announcements, so we are not able to make detailed comments regarding the root cause of the cash flow shortfall.

In broad terms, the fault lay with the two segments we have identified in recent calls and which were called out in the JP Morgan research report: Power and Oil & Gas. While not directly comparable to OCP, a look at the operating margins of these two segments offer a hint at the severity of the profitability drop.

Note that in the case of both segments, the revenue drop is rather modest, but the profit drop is enormous – 51% for Power, 69% for Oil & Gas. Managers explained that part of this drop in profitability was due to timing of certain payments and of orders that were pushed out into 2018.

To the extent that the drop in profitability is due to timing issues, there is no need for alarm. However, the entire drop cannot be attributed to timing issues, and Flannery suggested that original forecasts for certain service and equipment contracts had been overly optimistic. This immediately brought to my mind the JP Morgan analyst’s comments regarding an unhealthy corporate culture at GE, one facet of which involves mid-level employees being reluctant to give managers bad news.

We also wonder if there may not be an element of “kitchen-sinking” charges during this quarter. This is Flannery’s first quarter as CEO, so he can take charges on everything including the kitchen sink and the market will be more likely to blame the poor numbers on prior-CEO Immelt rather than on him.

In contrast, other segments performed well this quarter. Healthcare generated operating profit margins of 17%, Aviation, 25%. Renewable Energy’s operating profit margin was only 9%, but segment profits grew at a 27% year-over-year clip. Transportation, a segment facing a demand drought in the U.S. and difficult situations overseas (see the last story in this weekly news roundup article), was still able to generate operating profit margins of 26%.

The crucial issue raised by this earnings report in terms of GE’s valuation is that of the firm’s structural cash profitability.

We considered 2016’s 1% OCP margin as a one-off event, but the firm appears poised to generate similar OCP margins this year as well. If a “one-off” occurs twice in a row, it starts to look more like a “feature” than a “bug.”

If GE’s structural profit margin level was in the single-digit percentage range rather than our assumed low- to mid-teens range, our valuation range would need a drastic downward revision.

If, instead, the new CEO / CFO team of Flannery and Miller are taking advantage of their transition to kitchen-sink results, and long-run structural profitability is closer to the levels we presently assume, our valuation range may not move much at all as we incorporate 2017 results into our model.

Dividends

Cash dividends can only be paid out of cash profits, so any discussion of dividends should be framed in terms of cash profitability.

At the low- to mid-teens percentage OCP margin level – let’s say $10 to $15 billion of OCP in 2018, the payment of $8 billion in dividends will be easy for the firm to do. We estimate that the firm’s long-term growth capital spending needs are in the mid-teens percentage of OCP, so even $10 billion in OCP would be enough to pay both a dividend and make growth investments.

On the other hand, if GE is only capable of generating a low- to mid-single digit OCP margin, as it did in 2016, it will not be able to pay its present dividend. Full stop.

The Power business – one of GE’s most important in terms of revenue share – has entered into what appears to be a cyclical trough. The Oil & Gas business is at best also in the midst of a cyclical trough. If the shockingly poor profitability of these businesses continues in the short-term, indeed the company may be caught in the middle of the two extremes mentioned above. Maintaining the dividend is an important goal, but maintaining a dividend payout ratio of 100% limits strategic options and may leave owners in a worse position long term.

Flannery has set out to improve his odds of not having to cut the dividend by instead cutting costs. Rumors abound of global job cuts, consolidation of research and development centers, and cancellation of corporate car contracts. The “cost-out” goal for 2017 was $1 billion and today Flannery announced the company was roughly $200 million ahead of plan. Next year was meant to be a $1 billion cost-out year as well; Flannery has upped that target to $2 billion.

This will help provide a cash profit cushion that will make it easier to maintain the dividend, but the cushion will not come into place immediately. Restructuring brings charges and cash outflows, so the 2018 cost savings will likely be offset by higher expenditures related to the changes.

Flannery also announced today his intent to sell another $20 billion worth of businesses over the next 1-2 years. These divestitures will generate cash that might be used to buy back shares, which would allow the firm to pay the same dividend per share on a lower absolute profit.

The company has announced that “the dividend remains a top priority” and that is probably the best way to phrase GE’s present set of choices. We believe that the company will maintain the dividend if all divestment, cost improvement, and market expansion opportunities can generate enough cash to pay out roughly 80% of its Owners’ Cash Profits.

This 80% level would allow the company the flexibility to make appropriate growth investments. Were the payout ratio to increase too much over that 80% level, the firm may miss the opportunity to make necessary value additive investments, and this will decrease the value of the franchise longer term.

We believe a continuation of the current per-share dividend level is more likely than not, but acknowledge that there is a possibility the firm will be unable to maintain the preset pay out.

Overall View

Reading through the announcement this morning took our breath away. This period’s quarterly profit and cash flow numbers are shockingly bad.

We had expected the Power business and Oil & Gas to be weak (and have never held out much hope for Transportation), but the actual numbers fell far short of even what we considered a two-standard deviation worst-case scenario.

We realized that JP Morgan’s analyst, Tusa, had in fact grasped an important short-term weakness in the Power business. His forecasts for weakness in both the equipment and service component of the Power business were borne out by actual results.

However, even Tusa’s bearish earnings forecast (EPS of $1.60 / share for 2017) was a full $0.50 higher than the guidance announced by the company today. In other words, even the most bearish analyst did not conceive of how poor the profitability at the Power and Oil & Gas business might become.

Tusa, we believe, was also correct with regards to his views on the shortcomings of GE’s corporate culture. Flannery referenced this issue directly and indirectly on the call today, and acknowledged that the issue has been holding the firm back.

This is the first opportunity we had to hear Flannery conduct an earnings call by himself and we were impressed by what he had to say. We believe that he and the new CFO, Jamie Miller, are focused on the right things:

• Improving operational and managerial efficiency
• Creating a more robust and healthy corporate culture
• Accentuating the strength of GE’s franchises and generating cash flow

Flannery’s willingness to bring on a board member from the activist Trian Fund and to consider cutting the overall size of the board also signals to us that he is focused on improving strategic decision-making at the company. Judging by the market reaction to the earnings news today, we believe other investors were similarly impressed with the changes, because no one can be impressed by the numbers.

With regard to numbers, the pillar of our ownership framework is understanding the company well enough to accurately forecast best- and worst-case values for operational drivers. We have failed at that task for 2017.

We believe that our worst-case valuation scenario will necessarily have to come down as a result of this failure, though we will not know by how much until the numbers are published and we can analyze them.

However, this is not to say that the best-case valuation scenario might not increase as well when we reanalyze the firm. The one point that has come through to us is that our conceptual model of GE was anchored to its prior business model, which included a much larger financial services component.

As an owner, I was not sorry that the firm decided to spin out its financial services business. Indeed, I did not own General Electric until it had started selling off the lion’s share of that business because I was put off by one aspect of the leptokurtic nature of its return distributions.

The two defining characteristics of a leptokurtic distribution are:

1. Fat tails
2. Tall peak

Fat tails mean that events that should never happen in a Normally distributed world happen rather often. GE owners learned about this when the firm almost went bankrupt in 2009 because of the fat-tailed losses inherent in bubbly credit markets. This is the aspect of leptokurtic distributions that I wanted no ownership stake in.

However, after the firm began disposing of some but not all of its financing business, I came to appreciate the other aspect of leptokurtic returns: tall peaks. Tall peaks mean that most of the time, returns are very, very consistent.

When I originally looked at GE’s OCP margin numbers, I spotted the dangerous fat-tailed aspect of the financial segment’s leptokurtic returns, but forgot to adequately appreciate the consistency that the tall peaks brought.

GE has a portfolio of cyclical businesses. When cyclical businesses are in a trough, profitability falls. When GE’s portfolio contained a large, tall-peaked financing business, the steadiness of those profits counterbalanced the volatility of the cyclical ones.

When GE sold substantively all of its financing business, I cheered the jettisoning of the potentially harmful fat tails, but forgot that the usually helpful tall peaks would also drop out of the picture.

We are satisfied at the present time with our position and will reanalyze the firm, focusing on the cyclical aspects, when the company publishes its numbers.