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Morningstar | Culp Will Unlock GE’s Considerable Asset Value, Even Amid Near-term Free Cash Flow Troubles. See Updated Analyst Note from 20 Nov 2018

After taking a deeper dive into GE’s fundamentals, including a review of the firm’s third-quarter 10-Q filing, we lowered our fair value estimate to $13.70 from $16.30 per share. The primary levers driving our reduced fair value estimate are our reduced projections of the firm's power and renewable energy segments than we previously modeled, as well as reductions to our stage II assumptions. These are somewhat offset by greater-than-expected strength at GE Aviation. While we were originally bearish relative to the market in our assumptions at power, we were caught by surprise by the extent of recent pricing degradation in both the power and renewable energy segments, as well as the slow pace of converting orders into revenue at power.

Our new fair value estimate represents a 16% reduction to our prior fair value estimate. While some bears argue that as many as six of GE’s eight businesses add no value to GE, and that GE Capital is ultimately a negative $3 detractor to per share value, we strongly disagree. We believe the market has overreacted to a considerable string of recent bad news, and at a market price of about $7.70 on Nov. 20, 2018, GE shares represent a compelling 44% discount to our fair value estimate of $13.70.

The uncertainty bands around GE’s valuation have widened in recent weeks due to: a) management’s willingness to change its initial agreement on selling assets like BHGE shareownership; b) the unknown timing of dispositions; c) lack of management guidance; d) abrupt change in CEO after a relatively short term; and e) additional liabilities coming into view. We acknowledged these unknowns when we recently raised our uncertainty rating to very high from high.

There are important caveats, to our valuation, however. There are no quick fixes to the gas power business. While natural gas will almost certainly become an increasingly important part of the world’s energy mix, we believe overcapacity will endure in the power turbine supplier market over the next two to four years. We believe this portion of the power business won’t truly recover until the back half of the next decade. As a result, 2022 Gas Power Systems’ (a business line within the total GE power segment) estimated sales of $4.97 billion fall short of full year 2018 expectations of $5.1 billion in our model. For total power sales, we’re only modeling 2022 estimates of $29.3 billion, which cross 2015 levels, but fall short of the levels GE Power made in 2016 and 2017.

Moreover, while slowing natural gas turbine and service sales have punished the power segment, and looking forward, several concerns remain. First, we believe coal and nuclear power will have a diminished role as a part of world’s power mix, which will hurt the portions of power that thus far have performed better relative to the segment’s natural gas business. Second, renewables are still getting cheaper and have little to no environmental impact when compared with fossil fuels. Finally, while we still believe natural gas has a brighter future ahead, the threat of substitutes remains on the horizon.

Currently, natural gas proponents argue this source of auxiliary energy will serve to bridge the gap in the grid’s transition to renewable energy and solve the intermittency problem both solar and wind pose. That said, lithium battery costs continue to decline while technology improves. Even so, lithium batteries are a weak substitute for peaker gas turbines that supplement renewable power during seasonal dips. The massive amount of power required from lithium batteries would simply be uneconomical for consumers, even when accounting for a sharp drop in battery costs. This gives us confidence to model a modest recovery in gas turbine sales in the latter years of our forecast, even despite continued current challenges. We currently model Power segment profit margin to recover modestly by year 5 of our explicit forecast, returning from our estimated 1.9% in 2018 to the 2017 level of 5.6%. yet well below previous CEO John Flannery’s target of 10% and our prior expectations of 8.6%. We believe this acknowledges both longer-term recovery, as well as the challenging pricing environment and difficulty rationalizing supply to demand.
We also revisited GE Capital. There are various puts and takes in our reassessment of GE Capital, which we value at nearly negative $1 billion in equity value (minus $0.11 per share). Our valuation of Capital begins with tangible book value against management’s current reserves for mortgage, insurance, and litigation liabilities, as well as GE’s need to support GE Capital amid asset reductions.

We remain particularly concerned with CFO Miller’s comments that GE will need to make at least $3 billion in additional capital contributions. Currently, we model $3 billion in support for next year, and half that amount in annual support obligations during the five years of our explicit forecast. The timing of required contributions in our model could be off, but we suspect the aggregate obligation currently amounts to between $5 billion and $6 billion in a base case scenario, with no reserve currently offsetting this amount. Admittedly, this is the biggest unknown in our valuation of Capital, but it’s important to note we are nearly doubling the amount CFO Miller stated on the call.

We also believe the firm is under-reserved for its FIRREA mortgage obligation, as well as its insurance obligations. However, we do believe the firm has made adequate reserves for litigation expenses, which we believe will settle 25 cents on the dollar. Many of these litigation liabilities have settled in the interim between GE’s 2017 annual report and its 2018 third quarter 10-Q filing. In total we estimate these obligations, net of reserves, amount to nearly $12 billion, which more than completely wipes out GE’s stated tangible book value. However, we think skeptics overstate the extent of GE Capital’s liabilities.

We are using market-assessed enterprise values for both Baker Hughes, GE, or BHGE, and GE Transportation when determining what price GE would fetch for these assets upon disposition. We believe this is the best way to account for rational concerns that GE will not be able to collect the full intrinsic value for its disposed assets. BHGE, for example, currently trades at about a 30% discount to our analyst’s fair value estimate of $32 per share, thus we use the lower (market) value in our GE valuation.

Moreover, we continue to believe market concerns over liquidity are overblown. We believe GE has enough cash to operate its business between asset sales it can monetize in GE transportation, healthcare, and BHGE, as well as two lines of credit reiterated in a footnote on the firm’s third quarter press release totaling $40.8 billion, net of offset provisions. According to CEO Culp’s CBNC interview on Nov. 12, only $2 billion have been tapped from these lines of credit. These lines of credit are fully committed, with no covenants (we reviewed all public filings and management confirms). Moreover, to our knowledge, no bank has a disproportionate amount of risk underwriting these lines of credit. For example, one line of credit is extended by a syndicate of 36 banks. In summary, only in a bear case scenario do we model a $25 billion equity raise.

Finally, we’re encouraged by the margin of safety we currently see in the stock. We believe the bears are wrong with $9 worth of assessed value net of GE Capital liabilities. Even when deleting the contribution from six of the eight segments that exclude GE’s franchise business in aviation and healthcare, we believe the stock is worth nearly $11, even when attaching all probable liabilities. We reiterate our thesis that Culp will unlock GE’s considerable asset value, even amid near-term free cash flow troubles. Ultimately, we believe near-term catalysts in the stock include: 1) GE transportation’s merger with Wabtec in early 2019 and the firm monetizing its remaining interest; 2) GE’s separations of Healthcare and BHGE; 3) a potential sale of GECAS, combined with liability ringfencing; 4) potential asset sales in portions of GE power; and finally, 5) facility and headcount reductions at GE power and GE corporate in line with peers. At this juncture, we only model items number 1, 2, and 5, as these are items GE has explicitly committed to.