General Electric's recent annual report left readers scratching their head. The company operates in nine, materially different segments, and comments on each segment as if the reader is expected to understand the risk facing the oil industry and the healthcare industry. To analyze the financial statement of a company with one operating segment is a challenging task; it is exponentially harder in the case of GE.
To explain its operating results, GE came up with its own definition of financial performance metrics. Those metrics include imaginative terms such as "EPS from continuing operations", "GE Industrial plus verticals EPS" and "Adjusted GE Industrial CFOA". With so many adjustments to reported earnings, we must wonder whether they are meaningful at all.
Not only is it difficult to understand the meaning behind the definitions, the annual report contains typos. On page 102 of the annual report, management makes an error as it reports on $9,698 million in adjusted GE industrial CFOA. It should be $9,168 million.
There is no way around it: GE reports on a deteriorating financial health. If we look at the revenue from the sales of goods and services over the past six years, we find a compounded annual growth of 2% per year, from $101 billion in 2012 to $113 billion in 2017. But the operating expenses increased by three times as much. The operating expenses compounded growth was 6% during that time, from $75 billion in 2012 to $107 billion in 2017.
Another troubling fact is that GE's debt service increased from $1.3 billion to $2.7 billion during the 2012 to 2017 time period. So the gross revenue to interest expense ratio has steadily declined over the past six years. It was 19 times in 2012; six times in 2015; and merely two times in 2017. In numbers: GE revenue was $113 billion; its operating expenses were $107 billion; gross revenue was $6 billion and with an interest expense of $2.7 billion, the coverage ratio is 2.2 times.
The dismal trend in operating performance is found in GE's balance sheet too. In 2012, the company had $600 billion in tangible assets and $557 billion in liabilities for a tangible equity balance of $43 billion. In 2015, total tangible assets were $410 billion, and liabilities were $389 billion, for a tangible equity balance of $21 billion, a drop of 51%. Two after, in 2017, the tangible assets were $274 billion and liabilities were $292 billion. A deficit in the reported equity account. In other words , the accountants reported that GE will not be able to pay off its liabilities (let alone the common shareholder) if it is to sell all of its assets as reported on the balance sheet. Yikes.
It is practically impossible to proselyte where GE will be in five years. A month ago, GE announced that it will be selling its 62.5% interest in Baker Hughes. A year ago, Jeffrey Immelt retired as Chief Executive Officer and three and half years ago, on April 10, 2015, GE announced it would sell most of the assets of GE Capital.
There have been so many changes; how can one see the distant horizon? With no idea where GE will be in the future, I thought about valuing GE by simply adding up the market value of its subsidiaries, as if they were separately owned entities. But here too I ran into a difficulty. Separately, GE does not report who is the competition for each of its subsidiaries, and given its behemoth size, GE is simply too big for a competitor to purchase its assets entirely.
In a day-to-day business transaction, a prospective buyer usually asks: What am I getting by investing my cash in this business? The answer is usually how much cash flow will be returned, and what is the value of the asset being acquired after any liabilities are paid off. In the case of GE, it is guessing a game to determine either of the two.
The (opaque) valuation
Between 2012 and 2017, the stock traded as low as $17 (in 2017) and as high as $33 (in 2016). I believe there are many investors who estimate that the stock value is now somewhere worth somewhere between $20 to $25 per share. Let us assume that it is the case for the remaining paragraphs.
Even if the stock is worth $25 per share, given the uncertainty, GE is not a bargain. Grab your HP12C and you will find that assuming that GE's stock price will reach $25 five years from today, the expected rate of return is 14%. Including the expected dividend per share of $0.48, the expected rate of return is 17%. A less than adequate return given the amount of uncertainty.
This meditation is an example of when the best investing idea is the one you do not invest at all. What drew my attention to GE in the first place was a precipitous decline in the stock price. Excited about the opportunity of purchasing stock for $14, I quickly learned some hard truths; that management halved the dividend rate in the last quarter of 2017 from $0.25 to $0.12 per quarter; and that management took a significant impairment expense of $6.2 billion last year with little explanation.
In February of this year, I bought 100 shares of GE at a total cost of $1,474. (It represents about 0.59% of the total cost of my portfolio of stocks.) I bought those shares just to force myself to read more about the company. I am glad I learned more about GE and I am also glad I am no longer a common stock holder. The word of GE is simply too confusing for me.