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Looking for a Bright Spot this Week? Look at GE

David Borun
Looking for a Bright Spot this Week? Look at GE

It goes without saying that it’s been a rough week for the broad markets. Since the opening of trading last Thursday, the Dow and S&P 500 have shed about 3% each and the Nasdaq Composite is down 5%.

The reported reasons are many, but a recent rise in long term interest rates tops the list with the yield on the benchmark 10-year U.S. Treasury notes hitting 3.25% - a 7-year high. Concerns about a weakening economic picture in China and lingering fears about the trade war have also been putting pressure on U.S. equities. Even the effects of a major hurricane bearing down on the Gulf Coast seem to be weighing on investor sentiment, though the long term economic effect of a big strike is uncertain at best.

One of the best performing stocks during the last week is General Electric (GE), which is up 10% over the same period and more than 20% above its 52-week low. Even on a day when the Dow shed more than 500 points at its lows, GE is eking out a modest gain, up 0.5% at midday.

After years of poor performance culminating in GE’s replacement in the Dow Jones Industrial Average earlier this year after 121 years in the index, investors finally seem to be seeing some rays of sunshine, particularly in a management change announced last week in which former CEO John Flannery – who served in the post for just over one year – will step down and be replaced by Lawrence Culp.

GE shares rallied immediately on that news and have built on those gains, even as the broader markets have lost ground.

Let’s take a look at some of the factors that have investors taking another look at this previously out-of-favor industrial giant.

Turnaround Finally on Track

After years of underperformance and a resulting dividend cut, GE announced in November of 2017 that it would be selling approximately $20B in assets to concentrate on the industrial core and specifically to shed exposure to the troubled oil and gas business.

GE also intended to entirely revamp the power generation division which – despite being the producer of industry-leading technology – had been dragging down overall results. The reported cause was bad management that had poorly projected changes in the industry that allowed inventory to pile up.

More focus would be paid to the outperforming aerospace and healthcare businesses, which the company described as having “real opportunity for organic growth.”

Progress was slow however, and earnings at GE continued to decline. Current estimates for full-year 2018 results are for a decline of more than 10% from 2017 levels.

The current price performance seems to suggest that investors didn’t think that the overall plan was misguided, but rather that Flannery was not the right man for the job. Culp appears to be a more dynamic and results-oriented leader, having been the CEO of Danaher during a period when that company grew fivefold with the help of many successful acquisitions.

In all fairness, Flannery took over at a low point in GE’s history and presided over the lion’s share of restructuring pain, while Culp will inherit a much leaner enterprise. Consequently, investors will definitely hold his feet to the fire over the expected recovery in earnings.

Debt Issues

A common complaint early in 2018 was that although GE was shrinking its footprint in unsuccessful ventures, it was not significantly reducing its debt load, which had tripled between 2013 and 2017. The company also held insufficient reserves for pension and retiree healthcare obligations and an overall debt-to-earnings ratio of 3.7X, considerably higher than the industry average of 1.5X.

These concerns led to a downgraded credit rating which S&P Global Ratings explained was due to "higher leverage and poor cash flows."

GE's $20B in asset sales will help to considerably reduce the debt load and a combination of improving cash flows from core businesses, a reduction in losses from underperforming units and a reduction in the dividend will allow GE to continue paying down existing liabilities.

Ironically, rising interest rates will also reduce the burden of the pension shortfall. Low interest rates used to calculate pension obligations have the effect of inflating those obligations. GE estimates that every 25 basis point increase used in the pension discount rate lowers the total liability by $2.4B. Though this may seem like merely an accounting anomaly, a reduction in pension liability makes GE more attractive to lenders and investors.

Though higher interest rates are generally considered a headwind for stocks, paradoxically they offer GE some relief, at least in terms of the pension issues.

Is GE a Buy Here?

Though investor sentiment seems to be changing, analyst earnings estimates out into the future have yet to improve and GE remains a Zacks Rank #4 (Sell). Even with all of the apparent good news, this is still not the GE of old. There’s still a long way to go to restore GE to its status as one of the country's strongest enterprises. At this point, the investment risk looks closer to an average speculative growth stock than a mighty industrial.

Wise investors might want to tread lightly, especially after recent price gains. Good things are certainly starting to happen, but at the levels GE is now trading, it’s likely there will still be time to wait for some solid actual results and still get on board.

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