Another Shoe To Drop At GE?

Seeking Alpha

GE’s Q4 Industrial profit fell 39% Y/Y due to problems in Power Systems and a decline in Transportation.

Power is being disrupted by Renewable Energy and Transportation.

The SEC is investigating GE’s methodology for determining its insurance reserves. This could be the next shoe to drop.

GE remains a Sell.

General Electric (NYSE:GE) reported Q4 revenue of $31.4 billion and EPS of -$1.23. The company missed on revenue and earnings, but gave expected adjusted earnings for 2018 of $1.00-1.07, which was similar to a consensus of $1.06. However, its reserving practices for long-term care policies could be the next shoe to drop for the industrial giant.

Power’s Demise Continues
Revenue for GE’s core Industrial products grew 3% Y/Y. The results were not totally apples to apples, as Oil & Gas revenue included its merger with Baker Hughes (NYSE:BHGE) – GE’s majority stake in BHGE’s revenue was $5.8 billion, up 69% Y/Y. If you back out the results of Oil & Gas, then Industrial revenue would have fallen by 5% Y/Y. This could be the new normal for the former bellwether which is now subjected to the vagaries of the global economy.

General Electric (NYSE:GE) reported Q4 revenue of $31.4 billion and EPS of -$1.23. The company missed on revenue and earnings, but gave expected adjusted earnings for 2018 of $1.00-1.07, which was similar to a consensus of $1.06. However, its reserving practices for long-term care policies could be the next shoe to drop for the industrial giant.

Power’s Demise Continues
Revenue for GE’s core Industrial products grew 3% Y/Y. The results were not totally apples to apples, as Oil & Gas revenue included its merger with Baker Hughes (NYSE:BHGE) – GE’s majority stake in BHGE’s revenue was $5.8 billion, up 69% Y/Y. If you back out the results of Oil & Gas, then Industrial revenue would have fallen by 5% Y/Y. This could be the new normal for the former bellwether which is now subjected to the vagaries of the global economy.

Equipment orders were down 5%, organically driven largely by a decline in Power on lower aerospace orders and gas turbines. Lower orders from Power were partially offset by Healthcare, which saw orders increase by 9%. Services revenue also was off 5% driven by Power, and offset by growth in Aviation, Renewables and Healthcare.

The decline in services revenue is particularly damaging because it was expected to be a catalyst for GE’s $10 billion acquisition of Alstom’s (OTCPK:ALSMY, OTCPK:AOMFF) power business. The transaction was expected to create a turbine-services backlog of $50 billion and about $3 billion in cost synergies. It appears the services backlog may not materialize like previously thought. Also of note is that Transportation revenue was down 20% on lower equipment volume. Going forward, top line growth could be determined by the continued demise of Power and whether other segments can hold the line.

Segment Profit Off 39%
GE’s Industrial segment profit of $3.5 billion was down 39% Y/Y. The company’s profit margins fell from 17% in Q4 2016 to 10% in the most recent quarter. There was some noise related to a $105 million loss at Oil & Gas – ex-Oil & Gas, the company’s segment profit margin would have been about 13%. Segment profit for Power was $260 million, down 88% Y/Y. The shift in demand for heavy-duty gas turbines from 46 gigawatt to 40 gigawatt has been well-documented. However, Power is being disrupted by a structural shift to renewable energy. GE’s Renewable Energy segment grew segment profit 25% Y/Y.

Power had a segment profit margin of 19% in Q4 2016 versus 3% in the most recent quarter. Renewable Energy had a 7% profit margin in the most recent quarter. I anticipate more of GE’s energy business will shift to Renewable Energy and the segment will experience high-single digit margins for a sustainable period.

Whether cost take-outs and growth in other segments can offset a decline in Power’s segment profit remains to be seen. In Q4, Healthcare demonstrated double-digit growth in segment profits, while Transportation fell by 40% Y/Y. GE’s cyclical businesses appear to be subjected to the vagaries of the global economy. That is a scary thought given that central bankers could soon end their stimulus packages aimed at propping up the global economy.

Another Shoe To Drop?
In addition to the Power segment, GE Capital could be another cause for concern. GE recently announced it needed to make $15 billion in reserve contributions to its insurance operations over the next seven years. The lion’s share of the reserve increases were related to long-term care, which has suffered from an aging population and more claims than anticipated. The additions to reserve could hurt GE’s cash flow in the near term.

Now, the SEC is investigating the company’s internal controls and bookkeeping pursuant to its insurance reserves:

Around the insurance industry, long-term care policies have been hurt by soaring healthcare costs and longer life expectancies. Other insurance companies have been forced to book losses in recent years.

But it wasn’t until last week that GE announced a $6.2 billion hit and warned it will devote $15 billion to boost insurance reserves.

GE said the SEC is probing “the process leading to the insurance reserve increase” as well as the fourth quarter loss.

Lynn Turner, former chief accountant at the SEC, said the insurance problems raise questions about GE’s controls and bookkeeping.

“GE seems to be way behind the 8-ball on this. Others have been boosting reserves and GE hasn’t,” Turner said.

Market chatter suggests rising payouts for long-term care providers has been known throughout the industry. If GE has been late to increase its reserves, then the SEC might want to know why. At a minimum, an investigation could cause a distraction for management when it can least afford it. It also could cause GE to change its reserving practices, or cause the SEC to potentially look askance on other reserving or revenue recognition practices at the company.

Conclusion
Problems at GE Capital and margin erosion at Power make GE a Sell.

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