Sunday, February 18, 2018

The importance of GE's credit rating

The cover story in Barrons this week is on GE's dim prospects. I confess to being a very minor source for that story. I don't own GE - but there is a price below the current price where I would buy it.

That said, I think there is one last shoe to drop, and it is a doozy. And it wasn't covered in Andrew Bary's excellent article. That is that GE's credit rating - and hence its business - is under threat.

GE's best business (by far) is jet engines where it competes with Rolls Royce (in wide-bodied engines) and a Pratt & Whitney consortium in narrow bodied engines. 

There is a new generation of engines (and planes) now - and the aviation business is booming. Boeing's stock price reflects that.

But GE is no longer the unequivocal engine leader. In wide-bodied (ie planes with two aisles) the current leader is the Airbus A350 powered by a Rolls Royce engine. It is the most fuel efficient long-haul plane on the market (measured in fuel cost per passenger-mile) and the engine is provided exclusively by GE's competitor. GE is playing catch-up - but will probably succeed with the Boeing 777x which (on paper anyway) will take the mantle as the world's most efficient plane.

In narrow-bodied the GE may still be the leader but Pratt & Whitney has caught up a great deal. Picking the competing engines apart is difficult (although at the moment the Pratt & Whitney competition has problems with a knife-edge seal). [I know serious aviation nerds who think the P&W engine is a better product with better prospects - although I think that is a minority view.]

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The jet-engine business is threatened by GE's current worries. You see jet engines (especially wide-bodied jet engines) are sold with very long-term maintenance contracts. If I order a 777x now it will be a couple of years before the first delivery, maybe 10 years before my delivery and expect to be flying the plane for another 20-25 years after that. I may be ordering 10 planes in which case my last delivery may be 15 years away and I expect to fly that plane for a further 25 years. 

Whoever buys this plane needs to be confident that GE will be around and solvent in 40 years to actually do the maintenance. The GE aviation business is more credit sensitive than almost any business I can think of.

And that is a problem because as Andrew Bary notes GE's debt is already trading as if the credit rating is BBB+, and if you are entering very long maintenance agreements BBB+ is simply not good enough.

If Ahmed bin Saeed Al Maktoum or Akbar Al Baker gets jittery re GE's credit rating then it will threaten GE's ability to sell engines or even Boeing's ability to sell planes (on which GE is the monopoly engine provider). 

Who are these guys you have never heard of? Well Ahmed bin Saeed is the CEO of Emirates airline and Akbar Al Baker is the CEO of Qatar airlines. These are the biggest buyers of long-haul jets in the world. They are GE's most important customers.

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GE is, I think, a rationally run business - meaning management run it to management's incentives. In the old days that was to buy stock and keep the price high (options) but now it is clearly just for business survival.

And business survival requires that GE maintain its credit rating. 

That is why there will be an equity raise.

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There are plenty who argue that GE should be broken up. I am not averse to the possibility but it is much harder than it looks. GE has lots of obligations including over 100 billion in debt and 30 billion in pension shortfalls. It also has guaranteed a few (painful) insurance obligations.

If you break up GE those obligations have to go somewhere. And debt holders or the Pension Benefit Guarantee Corporation is not going to accept them being placed against GE's troubled businesses (such as power systems). And Ahmed bin Saeed isn't going to accept them being placed against the aviation business.

So in a break-up a lot of capital needs to be raised. Probably in excess of 50 billion. 

Bluntly I do not think a break-up is realistic. You could get away with under half the raise if you don't break it up. And maybe you could just sell some businesses to strengthen the balance sheet and get away without a raise.

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Rolls Royce went through this. There was a period where Rolls was problematic - and if you looked at the balance sheet you would have immediately rated it A+. But even then A+ was barely enough - even the threat of a downgrade and Rolls would have had to raise capital to protect their business.

Rolls never raised equity - but it was touch-and-go. 

GE is far more problematic than Rolls at the nadir - simply because there are far more obligations on GE's balance sheet.

I reckon an equity raise is likely. I don't know why they didn't cut the dividend in its entirety (except maybe that wasn't enough). It may be that 20 billion in asset sales is enough - but I have my doubts. I think they will need more to keep the customers satisfied. 

Ahmed bin Saeed Al Maktoum, this one is up to you.




John

POST SCRIPT: I have been asked several times how GE got into this trouble. Here is my very quick summary.

a). GE was left hyped up and overly dependent on finance income and accounting tricks under Welch (who I think is the main culprit here),

b). Immelt did not defuse all the unexploded Welch bombs anything like fast enough. GE would have gone bust on the Welch trajectory, and Immelt got it off the Welch trajectory, but not far enough off the Welch trajectory, and

c). Both Welch and Immelt behaved as if their body odour was perfume. They believed their own hype and bought back stock and stock and more stock. Total shares repurchased were over 100 billion dollars. Just 30 billion of that money now would solve the credit rating problems.

d). Power systems which was once perhaps the golden business fell on hard times. Solar is now cheaper than coal or gas. Renewables are cheap. This is a problem if you are the biggest capital equipment sellers to the old tech. This was exacerbated by spending 10 billion on Alstom just as it all fell apart. Immelt doubled down on dying technology.

The 20 year accounts are here.

41 comments:

Saurabh said...

Barron's was wrong when they recommended the stock at $29, and they will be wrong now casting doubt on LT prospect of stock at $15. Whole rationale of story is weak. A bearish analyst is coming up with a $13 valuation (after accounting for pension underfunding). So that is ~15% downside to a bearish intrinsic value estimate. Granted he does say it could overshoot to the downside at $10, OK so doomsday scenario is ~35% downside. I don't think the time is right to take a long position in GE because these turnarounds take time. But it is more appropriate to be thinking about when to go long GE than shorting it.

John Hempton said...

I said there was a price I would go long.

The only position I have ever had in GE prior to this was short.

I am fairly convinced that the credit rating situation is very bad - and I would not go long prior to evidence enough capital has been raised. That will likely be an equity raise.

At worst case it will be something like a partial sale of the best business (engines) to Berkshire in exchange for some cash and some Berkshire guarantees.

CrocodileChuck said...

How did Jeff Immelt get an American icon into this feeble position?

And why are the pension obligations so underfunded?

John Hempton said...

"How did Jeff Immelt get an American icon into this feeble position?

And why are the pension obligations so underfunded?"

a. did not close/sell the finance business fast enough. It was a disaster under Wendt, and the bombs exploded under Immelt, and

b. Way too many buybacks.They rogered their own balance sheet buying back stock.

Unknown said...

Rating agencies in the past cut GE a fair bit of slack - it was critical / under threat as far back as 2007, though concern was more on the finance businesses then. Probably less wiggle room now given reforms the agencies have undertaken.

CrocodileChuck said...

Idiot [Immelt]

Clayton Christiansen was correct: 'The Capitalist's Dilemma: The Tools We Use to Guide Our Investments Are Blind to the Best Opportunities for Creating New Jobs & New Markets'. HBR, June, 2014

CrocodileChuck said...

ps I suspect the executive bonuses in this period weren't 'underfunded'.

TRANSLATION: paid in full.

Anonymous said...

B. "Returning value to shareholders" is what I think you meant to say...

Anonymous said...

Thanks John, great post. Question: Does Emirates at al. really care about credit rating? Aviation is an extremely profitable business, particularly the longest tail piece (service). The business wouldn't ever be shut down in a GE credit event... worst case it would just be operated by someone else (Berkshire?).
Thanks again

Anonymous said...

Can you please review the article... It has to be an "Autocorrect" problem!
I believe you are referring to Jack WELCH as "WENDT"!

m.- said...

I believe you meant WELCH not WENDT (Autocorrect?!?)

Brian said...

CNBC had asked me to take the bear side on GE back in the summer, the segment never ran, but I just published this article about the cursory research overview I did for the TV hit. https://www.zacks.com/commentary/149609/the-time-i-didn39t-talk-ge-on-cnbc

Anonymous said...

It's true that a GE Aeroderivative gas turbine like the LM6000 costs more to run than a wind turbine or solar panel but that's not enough to deem it a dying technology.
It's great advantage is its ability to start in 10 minutes, unless there are immediate dramatic improvements in battery storage then it will remain in the lead for the indefinite future.
https://www.geoilandgas.com/LM6000PFplus
The Alstom acquisition included the GT36 which they had to divest, that may have changed the outcome.
https://www.ansaldoenergia.com/business-lines/new-units/gas-turbines/gt36
It's great advantage is that the dual combustors enable it a flexible turndown range without shutting down. Shutting down a Combined Cycle Gas turbine incurs maintenance penalties and takes like 8 hours so it's not something you want to do.
These technologies are very far from dead, I think you are correct about the maintenance contracts but what's the alternative. The average utility is far from radical and would be hard pressed to move away from a maintenance contract with an Original Equipment Manufacturer despite the fact that it is absolutely price gouging.
Surely the companies responsible for airlines would be even more conservative/gutless.
The belief that fossil fuel technology is dead is driven by the cult of Elon Musk, while this is the future I want to see from an investment perspective it will almost certainly take longer than people expect.
Somewhat like the dotcom bubble, people were ultimately right that online would change many industries but were about ten years too early and when you pay 100 times prospective industry.
Self inflicted injury - no sympathy.

John Hempton said...

Welch/Wendt was a little faux pas. Wendt was CEO of GE Finance - and I think the guy responsible for much of the mess.

I was thinking Welch and confused. Wendt I shorted when he was CEO of Conseco.

CrocodileChuck said...

Gary Wendt ran GE Capital 20 years ago [up to 1998]

Its amazing how a great corporate like GE, which excelled at training & developing leaders within the enterprise, produced so many duds, once they spread their wings:

http://www.slate.com/articles/business/moneybox/2003/03/do_they_know_jack.html

To this league table of woebegone executives must be added one more:

Jeff Immelt.

Anonymous said...

Can GE engine customers really switch to a competitor, bearing in mind how all engine makers have very long backlogs? This has been one of the bull case arguments for Pratt & Whitney through the ongoing problems with the geared turbofan engine, and so far seems to have proven correct. Also, any customer switching away from GE engine would have to go with either P&W (with its delays) or Rolls Royce (also not in great financial shape; I have heard Airbus people expressed doubts about RR balance sheet too).

Charl Lishman said...

Any good articles or reliable sources / references to study as to what forms of energy are the most efficient / cost effective ?

Alan Richards said...


Thanks for your 20 year financials spreadsheet - it brought back a few memories. I tried to sell a UK business to GE back in 2000. Quite small but everything had to be run by Jack. GE's market cap was £500bn back then, the world's largest company for a time.

There were plenty of skeptics even then as you can see from this Fortune piece in 2001.

http://archive.fortune.com/magazines/fortune/fortune_archive/2001/02/19/296891/index.htm

The concerns in this article were managed earnings, Hudson River pollution and the $20bn takeover of Honeywell. The EU Competition Commissioner Mario Monti blocked the GE/Honeywell deal, something for which Honeywell shareholders should be eternally grateful given their relative performance since.

HSNYC said...

A lot of GE's historical businesses were very clearly subject to earnings management. Welch clearly used these tools to accomplish one of the longest records of quarterly EPS beats of all time. The ability to manipulate earnings has fallen over time as some of these businesses have been divested (the fewer you have, the harder it is). Nardelli recently spoke about this earnings management on CNBC completely unaware that this is the root cause of the all the problems (jump to about 2:30 for earnings management discussion)...

https://www.cnbc.com/2017/11/13/ex-ge-transportation-ceo-its-painful-to-see-the-dismantling-of-this-legendary-company.html


If you look at the history of GE's business exits, there is clearly a pattern. Either GE takes a big hit when they announce intent to sell or the acquirer/spin take big hits further down the line - often both.

GE Capital was always too levered. But I wouldn't let Immelt off that easy. The business almost doubled in size under his watch, despite getting out of insurance. It also owned international real estate (rather than loans against real estate) going into the last crash with practically no equity capital. The reason GE capital had to do all of this is because GE never wanted to repatriate (and pay taxes on) earnings from abroad. So it had to constantly look for place to put capital outside the US. It didn't help that the market wanted to put a 20x multiple on all of GE's earnings, rather than just the industrial side. Given the fact that there was almost no equity capital in GE Capital the returns to be had on incremental capital were excellent and far easier than deploying capital intelligently in the industrial business.

More recently the earnings management had come from more creative accounting. Specifically GE started to book part of the revenue associated with service contracts (mostly Power and Aerospace) upfront. Given what we know about the management incentives (all based on accounting profits), this likely encouraged taking bigger losses upfront since management was able to book service contract profits alongside. The aggressiveness of GE's accounting is now obvious due to the implementation of the new FASB revenue recognition standard. At virtually every other company this has resulted in higher revenue. At GE, substantially lower revenue. The only way to really know exactly how good GE's engine business might be is for GE to disclose the "contract assets" booked each year so that we know how much of the revenue is cash revenue. Sadly they still have not broken this out.

So it is difficult...

Anonymous said...

Great Post.

Until I can figure out GE's books I will pass. Way too complex and confusing. Which I believe was done on purpose.

Anonymous said...

John,
Credit rating is important and you may be right that A-to-BBB is the fulcrum instead of the usual BBB-to-BB, IG/HY, quality/junk divide, but you lean on ROLLS (A3 Negative/BBB+ Stable/) in your example saying as the new leader and that GE (A2 Stable/A Stable/A+ Negative) faces challenge on downgrade. But the credit ratings of GE still have a 1- and 2-notch differential advantage over ROLLS. Using ratings alone, how is it that ROLLS would not have a problem but GE does? Pratt & Whittney is owned by UTX, which also sports weaker ratings (A3 watch neg/A- watch neg) than GE. What am I missing from your commentary?

Keep in mind that rating agencies have history of providing very long leashes when it comes weakening financial profiles warranting downgrade - I would guess this to be especially true of blue chip conglomerates. That is to say, if you are correct, be prepared for your thesis to take much longer than you think - unless you want to call the credit rating analysts and prod them.

I think the real economic divide may have been AA-to-A. At AA, there was real rating quality separation (essential elite quality) and the downgrade from AA circa 2014 may be contributing to the weak results we see today. Like in the insurance industry, the market place no longer rewards A-vs-BBB, but can reward AA balance sheets.

C.Thwaites said...

Gary Wendt was indeed a disaster. He hoovered up every financial entity going in the 90s. Kidder Peabody was a huge loss. Many of the insurance gambles left long term liabilities on the balance sheet....Life of Virginia was an aggressive annuity writer and left gaping holes in its balance sheet. All under his (Wendt's) watch. Interestingly, GE's share price has fallen 54% from its highs. Its market value has fallen 64%. The magic of share repurchases at work.

Anonymous said...

Even before thinking about long-term contract, GE can't afford to be downgraded to BBB+ because of his financing needs covered by commercial paper. The CP market asks for a rating above BBB+ thus the first reason they will have to improve the balance sheet ASAP.

Deep Throat said...

Spot on re: GE John.....it's worth $12 in an up market & $8 in the long overdue correction. They've gotta get their house in order. I'd add that Immelt actually saved the company by paring back GE Capital, and accessing the Berkshire and GS Money during the crisis. He doesn't get enough recognition for that. But the share buybacks to goose the stock price & EPS, far in excess of the underlying economics, were the companies undoing.

Hope all is well.....

DT

Anonymous said...

Agree with Anonymous on the power business - the relative cost comparison is only one piece, would you rather own solar in California at $25/MWh or wind at $35/MWh?

I don't see how you can split power out. Turbines (wind/gas) have 30 year O&M contracts and no IPP/utility will gamble. You can't have a low rated business with those contracts. So you'd have to spin it off with a balance sheet as good as or better than today's GE. But that doesn't solve anything. Fundamentally, a capital goods business must be a high quality credit, I don't see any math that allows you to create high quality companies from GE's pieces without stiffing someone who won't let themselves be stiffed (or a buyer who will wildly overpay).

Side note: I don't know why Vestas and GE are in a mutual destruction pact on US wind turbine pricing. Perhaps there's some plan to sell that business as a growth story ahead of the PTC ramp down.

oldfairy said...

GE asset sale 25B will not solve the problem?

justaguy said...

In 1999 Welch was named "Manager of the Century" by Fortune magazine.

Edward Collery said...

Aren't the maintenance contracts where GE makes most of the money on aircraft engines and don't GE/Rolls often sell engines at a loss just to secure the maintenance contract?

If that's the case and these maintenance deals are home-runs for GE should the airlines really be worried about the credit situation at GE? Given how attractive and profitable the contracts are, even if GE files I can't imagine they'd try to reject or stop honoring the contracts in bankruptcy. Sure having a credit-worthy counter-party is pretty much always preferable (at least on the margin) but I'm not sure I see what the existential concern is for the aircraft engine business given the structure and nature of the maintenance contracts.

Seema Sapra said...

So why was GE management buying back stock. Is this a clue

"The company talks a lot of about cash returned to shareholders, so I wanted to see exactly what that was. In the most recently reported quarter, the company had repurchased $2.3B in stock and paid $2.1B in dividends.

Often times the repurchase of stock comes when executives and other insiders are selling stock and the company buys in back as part of a buyback program. I am not saying that insiders sold $2.3B, but those buybacks also come when big institutions might be looking to exit a position as well."

https://www.zacks.com/commentary/149609/the-time-i-didnt-talk-ge-on-cnbc

So did Immelt use GE to buy back stock from Warren Buffet?

Anonymous said...

John,

Any thoughts on reliability? Both Pratt and RR are having major issues with their new engines (A320NEO engines for P&W and all of the Trent 1000s for RR) while GE engines do not seem to have the same operational difficulties. Sure credit ratings matter but so does reliability...

Anonymous said...

John,

GE has a lot more than $30 billion in unfunded pension debt. Do a 10-K doc search for unamortized actuarial loss and you may be astonished at how large the shortfall truly is.

Denis B. said...

I remember the Air Canada bankruptcy protection in 2004, where GE capital was a major stakeholder in the refinancing. Coincidently , from then on all of the purchased airplanes have been Boeing powered by GE engines ( except for a few CSeries, it's a Montréal company after all).
You are making me tighten my Stopsell orders BTW... thanks for the great articles !

Anonymous said...

CFO said yesterday no equity raise.

Sergey said...

Why are people viewing GE as an isolated incident? It's just the tip of the iceberg. Here is a selection of companies that are viewed as "safe", which have more goodwill+intangibles than equity on their books:

MMM, BA,DIS,GE,HD,IBM,JNJ,MCD,PFE,PG,UTX,UNH,VZ,V.

And these are just the ones that are part of the Dow (14/30).

Now, some of them have good reasons for that, but most of them don't. They have been paying too much out in dividends and buying back too much stock. And now when rates rise, credit ratings fall, these companies will have to start cutting their dividends. And then people who have been valuing companies based on dividend growth model are going to wake up to some very unpleasant reality.

David H. said...

Thank you for your post.
Any thoughts on possible repercussions on Safran, the other half of the CFM International ventres, besides how doubly foolish their acquisition of Zodiac now looks with this potential opportunity arising from GE weakness ? Are you seeing a pair trade ?

Len Rosenthal said...

Brilliant (both in the American and UK sense) observations on Welsh had me fooled and obviously many others. Looking back at the long arc of history, I remember reading and presenting to my classes (grad and undergrad) a WSJ article around 1996/1997 (don't hold me to the date) explaining how GE management was masterful at manipulating their earnings all within in GAAP. Of course, everyone ignored it as the bull market was roaring, including GE's board, which were putty in Welch's hand.
I would like one new, perhaps not so new piece of information. It seems that Rolls has some significant problems with with Trent engine that appeared today in Bloomberg https://www.bloomberg.com/news/articles/2018-04-13/dreamliners-longest-trips-face-curbs-on-rolls-royce-engine-woes.

jonathan hale said...

why have you stopped blogging so often John ? It used to be a highlight read for me now there are precious few and i doubt your inquisitive mind is taking a holiday

jonathan hale said...

Hi John, just wondering why you are publishing significantly less blogs when i have no doubt your inquiring mind has not taken a break. cheers and hope to get more blogs

Anonymous said...

https://leehamnews.com/2018/04/27/32-boeing-787s-are-aog-due-to-rolls-royce-trent-issues-number-will-climb/#more-27064

Trent issues till..... 2022

intjsanctuary said...

Is Boeing buying GE's engine biz a possible outcome?
(I ask that with zero knowledge of any of the companies involved)

emthree said...

$GE was about 15 when you posted this article in Feb/2018. With $GE now at 11.74, would like to see a follow-up if anything has changed in the interim.

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