Valuation insights on general electric – general electric company (nyse ge) seeking alpha electricity and magnetism physics

#

General Electric ( GE) is very hard for the market to value at the present time. Hence its shares may be trading at a significant discount to its sum of the parts valuation. My initial thoughts in trying to place a valuation on General Electric was to focus on the value of the companies crown jewels, which are Aviation and Healthcare. However, staring me in the face was that the key to valuing General Electric is to figure out what the potential net worth of the Capital Division is, and whether that is positive or negative. The market won’t fairly value GE until it feels comfortable with the Capital Division. Right now the market is clearly very uncomfortable with the unknowns coming out of the Capital Division.

Needless to say the market was caught completely off-guard when General Electric announced the need to take a $15 billion charge to cover upcoming liabilities related to life insurance operations that it is no longer writing policies for and is allowing the policies to run-off. In fact it was a $9.5 billion pre-tax charge in the 4th quarter of 2017 and then an additional $15 billion pre-tax over the next seven years from 2018 to 2024. Here is the quote from "GE announced today that the comprehensive review and reserve testing for GE Capital’s run-off insurance portfolio, North American Life & Health (NALH), will result in an after-tax GAAP charge of $6.2 billion for the fourth quarter of 2017, and GE Capital expects to make statutory reserve contributions of ~$15 billion over seven years. The Kansas Insurance Department, NALH’s primary regulator, approved a phased contribution of ~$3 billion in 1Q’18 and ~$2 billion annually from 2019 through 2024." The only good news here is that the losses of $24.5 billion pre-tax can be quantified and factored into a valuation of General Electric. The company shouldn’t have any trouble handling the 2018 through 2024 contributions out of corporate wide cash flow.

The company lists three negatives related to its Capital Division in the 2017 Annual Report, including the insurance charges. " Negative: Charge of $6.2B (after-tax) from increased reserves related to run-off insurance operations, which we estimate will require approximately $15B of capital contributions over the next seven years; also incurred charges from strategic portfolio actions planned for EFS; pending DOJ investigation of WMC under FIRREA."

The WMC sub-prime mortgage lending operations are part of the Department of Justice’s investigation into the whole sub-prime mortgage lending industry back in 2006 and 2007. General Electric has had settlement discussions with the Department of Justice and set aside a charge of $1.5 billion in the first quarter to handle a settlement. This is probably sufficient since Barclay’s settled a similar dispute in March for $2 billion. Again, quantifiable.

The third negative listed are charges from the company’s strategic portfolio review related to its Energy Financial Services business. According to the 2017 10-K, GE "plans to take actions to make GE Capital smaller and more focused, including a substantial reduction in the size of GE Capital’s Energy Financial Services and Industrial Finance businesses over the next 24 months." In the fourth quarter of 2017 General Electric took a charge of $1.8 billion for the downsizing and restructuring of the two financial units. The two businesses to be downsized had assets of $35.7 billion at the end of 2017. Again, quantifiable.

The Annual Report states "Capital enabled $14.4 billion of industrial orders in 2017 and ended the year with $157 billion of assets and $143 billion in total liabilities." According to the first quarter 2018 10-Q, GE Capital had total assets of $146 billion and total liabilities of $133.8 billion. So total assets fell by $11 billion and total liabilities fell by $9.2 billion. This makes sense in light of the insurance charges mentioned above in the first quarter of 2018 of $3 billion. What it clearly demonstrates is that management is serious about shrinking the size of GE Capital and aligning its mission with the goal of supporting other parts of GE.

In the current corporate banking environment a minimum capital to asset ratio of 8% is preferred. With $146 billion in assets GE should have a minimum capital expectation of $11.7 billion. In fact GE Capital has an equity of $12.2 billion, placing it just above the minimum expectations. Due to known future insurance charges the capital ratio is a little thin. But it is not a lot thin. Barring another dramatic downturn in the economy it appears GE Capital can weather the storm and should not provide a significant drag on the rest of GE. In other words, it appears the markets deep concerns about GE Capital are somewhat overblown and the focus should return to what are the other seven operating divisions worth.

The total shortfall in the company’s pension plans totaled $34 billion at the end of 2017. Here the company has a plan to make additional multi-billion annual contributions to shore up its pensions. How the economy and the markets perform will go a long way in determining if the shortfall dwindles quickly, or perhaps even grows. But based on GE’s cash flow the company should be able to handle its pensions over the next several years.

The bottom line is it appears the market is discounting GE shares too much based on its short-term challenges. The company has two stellar units with organic growth; Healthcare and Aviation. Those two units alone should be able to fund the pension shortfall and any minor hiccups from GE Capital over the next several years out of organic cash flow. Additionally, with the rise in oil prices now could be a good time to monetize the Baker Hughes General Electric division by selling some, or all, of GE’s 62.5% stake in the business. Right now the market is valuing that stake at around $25 billion based on the price of shares in Baker Hughes General Electric ( BHGE). Now is a good time to pick up shares of GE before the market refocuses on the upside of General Electric’s underlying businesses.