GE legacy called into question

admin | November 9, 2018

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

GE and its legacy called into question

GE needs no introduction and yet as a corporate bond issuer raises so many questions. This one-time AAA corporate bond issuer now faces high-BBB ratings from all three rating agencies following what could only be categorized as a shockingly-high goodwill impairment charge in 3Q18.  The wide range of opinions have resulted in a volatile spread movement in recent weeks, leaving more questions around the company’s future, and as we go to press, the stock is in a near free-fall on negative equity views from the Street.

A slow burn

The slow burn at GE has come in the form of big charges, most recently with the $22 billion charge for a goodwill impairment in the power division. In February 2018 the company had also taken a $9.5 billion pre-tax charge to cover long-term care insurance portfolio obligations. This is a legacy cost from the days when GE still owned Genworth in the GE Capital business. The GE Capital business remains on the hook, and will contribute a total of $15 billion to the reserve fund for legacy long-term care costs for GE. This will take several years to pay and will prevent GE Capital from upstreaming dividends to the GE parent for several years. This certainly contributed to the rationale for the dividend cut to common shares, and reduces the firm’s overall debt-servicing capacity too. When all three ratings firms took GE down 2-notches in October, the specter of GE Capital played a role in the moves.

The most recent quarter showed the market that GE really is struggling to align the diverse and seemingly non-complimentary business lines into a sustainable track for profitability. The two strong performers among the GE businesses in 3Q18 were the aviation and healthcare businesses, with $1.4 billion and $0.9 billion of segment profits respectively. Since the 3Q earnings release GE has announced that it has agreed to sell the lighting division, which contributed only $26 million in 3Q18 profits on $385 million in revenues, and was down 18% year-over-year. Proceeds from the sale were not public, but will modestly improve the cash position for the firm. At the end of 3Q18, GE reported $9.1 billion in cash and adjusted free cash flow of $1.1 billion. Going forward the firm will preserve considerable cash due to the cut in the dividend to shareholders, which is expected to preserve $3.9 billion per year.

With spreads hitting new wide levels in the wake of recent analyst reports, we think the only potentially appealing story could be in the front-end of the curve, particularly as GE faces a very high hurdle getting past 2022. The company has $111.8 billion of total debt, with $44 billion of bonds maturing by 2022. This does not include $5.6 billion of perpetual notes that were the forced-conversion of preferred securities in 2015 that are callable in January 2021. The real liquidity hurdle will come in 2020 when GE has $18.2 billion of debt coming due, and then another $17.5 billion matures over the following two years. Current leverage and servicing figures do not look positive – with debt/EBITDA of 6.62x at 3Q18 and debt/equity of 2.4x, this could create a challenging marketing story amidst the heavy refunding calendar. GE has three bank lines maturing in 2020-2022, which in a worst-case scenario could offer a back-stop if the company faces a liquidity issue.

Exhibit 1: GE credit curve

* N.B. denotes GE capital funding, which has parent guarantee. ^ floating rate note; 3mL + 38 bp. Source: Bloomberg and Amherst Pierpont Securities.

Likes and dislikes on the curve

Beyond 2022 the future holds greater funding risks and it seems reasonable to expect that GE will be a very different looking company in 2022 than it is now. That said, we like the ’22 and shorter notes such as the GE 2.70% ’22 senior notes that have a 4.5% yield to maturity and are 40 bp wide of the BBB Industrial index. Conversely, we would avoid or reduce exposure to longer dated notes, as well as the GE 5.00% NC21 perpetual preferred notes, which are callable in January 2021. These notes have traded down to $85-handle and bear a strong chance of being extended by GE, given the call comes in the midst of a big maturity calendar. This is a large issue, as it was originally 3 preferred issuances before the GECC sell-off (Synchrony, etc) back in 2015.  The notes currently price with some expectation of extension risk, but could face more selling pressure as the market considers the risk of a dividend suspension or even conversion into common equity (ala Citigroup style). Nevertheless, the 3mL+333 bp reset level provides good protection for bondholders that can hold perpetual notes. Right now that would put the floating rate close to 6%, though that will potentially be subject to a transition to SOFR plus a spread and credit adjustment, as the market is scheduled to transition away from LIBOR by the end of 2022.