2023-09-27 09:32:18 ET
Summary
- General Electric's long-term outlook remains cloudy due to excessive financial leverage and liability levels.
- The company's valuation is stretched and vulnerable to a macroeconomic downturn.
- I remain worried a weakening global economy into 2024 could send business results into reverse and severely damage the stock quote, which has doubled over the last 12 months.
I have not written on General Electric (GE) in years. Over a decade of writing on Seeking Alpha, all of my efforts have been bearish suggestions because of one factor - too much debt and leverage. My last article in July 2018 is linked here . In kind, the long-term price trend for the stock has been down, although a strong upmove has played out during the past 12 months with investors more than doubling their money.
After the big jump in share pricing during 2023, several readers have quizzed me on my current General Electric outlook. So, this is where I stand today.
Despite restructurings, spinoffs, and assets sales over time, my long-term view remains roughly the same. I would sell and/or avoid purchasing shares in favor of other businesses utilizing less leverage. If we do get a serious recession or prolonged period of stagflation, current analyst estimates are way too optimistic. The bottom line is GE is fully valued today, where any macroeconomic downturn will dramatically hurt sales, cash flow and income results. To me, just buying short-term Treasuries at 5%+ for guaranteed yield makes more sense than owning GE, taking on unnecessary leverage and real-world risk with your investment capital.
I will say business prospects and the balance sheet setup have definitely improved from 2019-20. However, I still categorize the combined underlying valuation (after a doubling in the stock quote) and liability setup (admittedly with less debt than years ago) as VERY stretched, all but requiring a stronger economy to succeed for investors.
High and rising interest rates, inverted yield curves, slowing employment trends, alongside an overvalued stock market in the U.S. are together arguing in favor of declining wealth in America and an eventual recession. Historically, this macroeconomic setup has been really bad news for equity pricing and real GDP activity over the next 12-24 months. If you wish, readers can disagree and hope for a soft landing or growing economy in 2024. But overall, the closest parallels to today are 2007-08 and 1999-2000, just before the last two major recessions hit.
In summary, reviewing the cyclicality of industrial businesses underperforming during recessions, GE investors may be acquiring/holding greater risk than they understand going into 2024.
Overburdened Balance Sheet
Let's start out with a bit of good news for GE shareholders. Cash flow and free cash flow numbers have experienced a positive boost of late from a bunch of one-time items. Plus, asset sales and restructuring moves have lowered financial debt tied to interest expense in a truly positive way. Below is a graph of the relationship between cash flow and traditional debt back to 1990. 2023 has witnessed some of the strongest multiples in 30+ years, largely on the back of one-time restructuring gains (minus charges).
You would think the increase in cash flow generation in 2023 is related to a nice jump in profit margins. You would be wrong. Even after layoffs and streamlining decisions, the spinoff of divisions, and restructurings meant to increase profitability, margins overall remain far under the levels that existed before 2013, a decade ago. Below is a graph of gross, operating, and final profit margins back to 1990.
Wall Street analysts tend to be an optimistic breed, and they are projecting rising profits to continue, despite very limited sales growth. I would say current 2023-25 estimates are possible, but only if the global economy continues to grow and support GE's international operations. If not, the below listed P/E estimates of 25x results in 2024 and around 20x in 2025 will prove way off target, in my opinion (based on 36 years of trading/investing including four previous recessions).
At first glance, the reduction in debt and liabilities over the last decade looks impressive. Yet, when you dig deeper, even more cost-cutting work may be required to permanently send the stock quote higher. Below I have charted financial debt and total liabilities (quarterly) since late 2013.
The bullish headline news is after restructurings and financial engineering changes, debts have come down nicely. But the equally-bearish reality to ponder is assets and operating sales have also moved dramatically lower in step. When we look at total liabilities of $130 billion (including pension underfunding, environmental cleanup obligations, tax liabilities, accounts payable, severance payments due, lease obligations, debt, etc.), the ratio to reported net assets (book value including goodwill & intangible assets) has NOT improved much vs. 2017. My conclusion is General Electric remains one of the greatest users (abusers) of financial leverage in blue-chip America, regardless of lower traditional debt numbers.
How bad is the situation? Below I have graphed total liabilities as a function of cash flow from operations since late 1990. The present ratio of 21x years of regular cash flow to theoretically pay off all liabilities is stunning, and well above anything the company experienced before 2017. On top of this big-picture idea, all cash flow would be used to pay off IOUs and liabilities, meaning no dividends for shareholders in the future, and no reinvestment (capital expenditures or dilutive takeovers) would be undertaken to grow the business for decades!
Considering nearly all U.S. blue-chip organizations are trading under 10x a similarly constructed ratio of liabilities to cash flow, it is difficult to say GE is anywhere close to owning a conservative balance sheet setup.
Food for thought. Another company I like is NVE Corp. (NVEC), a small Minnesota semiconductor company that produces its patented spintronic chips in-house. This enterprise runs a balance sheet the polar opposite of GE. $23 million in annual trailing earnings, and $20 million in cash flow is matched against just $1.6 million in TOTAL liabilities. Essentially, NVE Corp. could pay off all its liabilities with just three weeks of regular cash flow (excluding the fact it held a good $53 million in cash and bond investments at the end of June).
On top of a highly liquid balance sheet, this company delivers some of the best profit margins in America, while growing at a rate around +20% annually, is priced at 17x EPS today, with a 5% cash dividend yield available to everyone that can find it. If you could pick which one to invest your hard earning money (and you do have a choice), GE or NVEC, why not select the better overall financial backdrop with stronger growth at a lower valuation???
Valuation Remains Extended
So, now let's focus on GE's valuation. A safe guess is a company with this much leverage would sell at a very low valuation to account for rising recession risk. Wrong... General Electric remains at a super-high valuation. The stock trades for 48x trailing "operating earnings" when you strip out special gains. In addition, price to sales, cash flow, and book value remain well above 10-year averages.
When we look at the sizable 2023 price gain affecting its total equity market capitalization, we find the premium spread between total company worth and actual "tangible" book value is the highest since 2018! This simple review of net hard assets like cash, receivables, plant & equipment, etc., highlights there's not much left for easy to sell physical assets minus all liabilities. So, on this score, General Electric may actually be getting quite overvalued again.
I do like to compare/contrast enterprise value vs. basic cash EBITDA and annual revenues. Below I have graphed a decade-long recap of EV ratios (including debt and cash levels, but not all reported liabilities). Unfortunately, these multiples at best argue GE is sitting near its 10-year "average" valuation.
Seeking Alpha developed its own relative comparative analysis of valuations for each company vs. peers and sector-wide operating ratios. SA gives GE an "F" Grade overall for its valuation today. The only bright spots on the table below are the GAAP income figures, which include one-time events/gains already fading in importance to long-term investors.
Final Thoughts
Weakening chart momentum is another worry, regarding the immediate share price direction. On the 18-month chart of daily price and volume changes below, ultra-slow volume demand in August and September is screaming for caution (boxed in red). Usually, low volume days appear near a top in the stock market and many individual securities. You will notice the high-volume volatility of April 2022 through January 2023 was more indicative of a major bottom in price for GE.
In addition, price is now below its 50-day moving average really for the first time since last October. Lastly, momentum indicators like the Accumulation/Distribution Line , Negative Volume Index , and On Balance Volume mostly peaked between June and July (the blue arrows).
I guess the point of this article is GE has definitely made some improvement on the traditional debt side of the financial equation. However, excessive liabilities remain, the valuation is again very extended, and a recession could mess up operating performance next year. When there are literally thousands of smarter investment choices on Wall Street, with lower valuations and stronger growth prospects, why not focus on them for your capital?
I rate GE a Sell and Avoid around $110 per share for long-term investors. Based purely on a valuation review, the stock is only worth $60 to $70, using the four basic fundamental criteria charted in the article (earnings, sales, cash flow and book value). And, a looming recession with the potential for sliding operating results argues even lower quotes could appear in 2024.
For bulls, operating earnings must hold up and/or beat current analyst expectations to keeps shares above $100. Three EPS beats in a row have supported an exaggerated run higher in price since the end of 2022. My thinking is today's projections will prove overly optimistic for the end of 2023 and all of 2024. So, shareholders should definitely keep a watchful eye on upcoming Q3 numbers released in October, alongside management guidance for Q4 and beyond.
What would change my mind? A far lower share quote may now be necessary to properly account for the long-term risks still inherent in this security. I would wait for material price weakness before seriously entertaining the idea of purchasing a position, beyond a one or two-week swing trade.
Thanks for reading. Please consider this article a first step in your due diligence process. Consulting with a registered and experienced investment advisor is recommended before making any trade.
For further details see:
General Electric: Still Overburdened With Liabilities