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GE operating turnaround mostly priced in

| January 31, 2020

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.

General Electric (GE) beat 4Q19 and FY2019 earnings estimates, though the most important headline was the reported recovery in operating results across their core business lines, including a return to profitability for the beleaguered Power unit. The bullish view maintained on the GE recovery throughout much of the past year was further rewarded as the stock surged more than 10%, and corporate bond spreads were several basis points tighter in the two days that followed, aided by a firmer tone in the broader market. Investors overweight the credit should consider moving towards a market weight in anticipation of a flatter overall performance in the name.

Earnings evaluation

GE reported 4Q19 and FY2019 earnings this week with adjusted EPS of $0.21 vs the $0.17 consensus estimate. Management revised their estimate for $2-4 billion of free cash flow for F2020, well ahead of the low $2 billion estimates that analysts held before this quarter’s results. The return to profitability of the Power unit in 4Q19 was balanced by  a substantial drop in orders on a year-over-year basis – a sign of its scaled down approach to the challenged business.

Cash bond and CDS spreads have also recovered sharply since their late August 2019 local wides (Exhibit 1). Execution on asset sales remains the key element for the credit story, but a return to operating success is a critical component to the long-term viability for GE, and the prospect of returning to single-A credit ratings.

Their target of 2.5x leverage remains ambitious, but they reported an improvement of net leverage to 4.2x at year-end 2019 from 4.9x in the prior year, with GE Capital moving to 3.9x from 5.7x on rapid asset dispositions. GE’s revised forecast appears contingent on customer Boeing’s projection for the 737 Max to return to service in mid-2020; for which the aviation unit manufactures the engines and represents a key revenue generator for the segment.

Exhibit 1: GE CDS and cash bond spreads

Source: Bloomberg/TRACE indications only, Amherst Pierpont Securities

Restructuring progress

While the story this week is largely tied to operating success, asset sales related to restructuring have been the important progress recorded to date since their difficulties hit a fever pitch in 2018. Reports emerged yesterday that GE may be close to selling their steam power unit, which is tied to the disastrous Alstom acquisition of 2015 that touched off many of its current challenges.

The Company’s core targets that have been in place since 2018, when Larry Culp was appointed as the new CEO, are as follows: $25 billion in net debt reduction, $15 billion cash balance, <2.5x leverage (A ratings), and for GECC $10 billion in asset reductions and 4x leverage. As stated above, they hit the latter targets for GECC, aided most recently by the $3.6 billion PK AirFinance sale to Apollo. Previous sales include: the Baker Hughes (BHGE) stake for $3.7 billion, the Wabtec stake – $2.9 billion, Appliances businesses to Haier ($4.8 billion in 2016), Water & Process business to Suez for ($3.1 billion in 2017), Industrial Solutions business to ABB ($2.3 billion in 2018). Some more recent smaller sales included Equity Energy Assets to APO (amount unknown), Solar Energy Assets (amount unknown), MRA Systems ($500 million), GE Ventures (amount unknown), and Healthcare Equip ($1.5 billion).

Paramount to the fate of the GE’s restructuring has been the healthcare business, which GE was first considering to spin-off in its entirety in cancelled move announced June 2018, which was hoping to achieve 20% to debt reduction, 80% to shareholders. Instead, GE chose to sell its BioPharma unit to DHR for $21.4 billion in a deal announced in February of last year. The deal is now expected to close by the end of the first quarter, and will provide the bulk of the heavy lifting when executed. Also off the table appears to be reports of a potential sale of the roughly $40 billion aircraft business, GECAS. Management has repeatedly shot down the prospect of a sale, despite rumors about APO coordinating a bid last year, as it is often viewed as the crown jewel of the few remaining components of the old GE Capital.

Though GECC has been in wind-down since 2015, potential charges remain an uncertainty for the credit. Management took a $15 reserve build last year that felt as though it had addressed many of its legacy issues, but there is no certainty regarding their legacy insurance exposures and the prospect of poor reserve development leading to additional charges. GE provided some guidance in that regard last March, but it was a bit murky. Within the remaining insurance book, 60% of LTC book is individual (vs group) and the company maintains about $30 billion statutory reserves for LTC, $46 billion total. On the plus side, GE benefits from a recent account change, which could potentially curb charges from the legacy insurance operations until next year, giving them additional time to execute before potentially disappointing investors again.

Bottom-line for bondholders

As GE comes closer to the final sale of the BioPharma unit, and subsequent debt reduction, much of the juice has been squeezed out of the GE trade that was available in late 2019. There isn’t currently much risk premium over the previous spread levels available ahead of the emergence of GE’s biggest fundamental problems (in 2018). Investors that have been overweighting the credit since last year should consider moving down to a more market weight posture in anticipation of a flatter overall performance in the name, and recognizing the prospect for negative headlines in the quarters ahead. There likely is some tightening still to be experienced on the final execution of the big healthcare sale, but it does appear much of it is already priced in.

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