GE's Credit Rating Is at Risk
General Electric Co.'s financial restatements call attention to risks that credit-rating firms won't be able to ignore much longer.
The industrial giant, whose shares have plunged more than 20 percent this year as it grapples with the fallout from a deterioration in its cash flow, provided more details late Friday on the impact to 2016 and 2017 financials from accounting rules changes. New standards for revenue recognition and other adjustments will result in a roughly $2.5 billion reduction to GE's 2017 industrial segment profit, more than what the company had estimated in November.
It's important to note that the restatements aren't connected to the SEC investigation into the way GE accounts for long-term service contracts. 1 Instead, the update is a fine-tuning of restatements GE has been flagging for a while now. But the official restated 2017 results should make it clear that GE's 2018 outlook is unrealistic and will likely need to be walked back. On that basis, it's hard to see how credit-rating companies can still be comfortable with their current outlooks.
Subtracting billions from GE's 2017 operating profit both inflates the company's leverage on a trailing basis and steepens the path to lowering that debt burden via earnings growth. GE will need to grow industrial earnings at a meaningfully higher rate than the 2 percent to 7 percent it had been targeting as of its November investor day to meet its goal of $1 to $1.07 in adjusted EPS, barring any outsize below-the-line gains. The company has already said it will come in on the low end of that range as a surprise $15 billion reserve shortfall at GE Capital caps that unit's earnings contributions.
Based on consensus Ebitda estimates heading into Friday, GE is tracking toward leverage of 4.6 for 2018 on a pension-adjusted basis, according to Bloomberg Intelligence analyst Joel Levington. For reference, after downgrading GE's long-term ratings in November, Moody's Investors Service indicated it could take further action in the absence of progress toward leverage of 2.5 times Ebitda. 2
Some GE bonds have already been trading at junk levels, well below the current A2 rating prescribed by Moody's, but another credit downgrade would still be a huge deal because it has the potential to increase GE's borrowing costs. GE still relies heavily on commercial paper funding, to the tune of an average balance of about $17 billion in the fourth quarter. Any pressure here would increase the urgency around asset sales, which risk being dilutive to both future earnings and cash flow. A tightening of the liquidity screws could also affect GE's ability to justify maintaining its 48 cent annual dividend (it already had to cut its payout in half last year).
It's a bad spot to be in, but GE is already there. And in that context, the rating companies look a little slow on the uptake.
Put a different way, these accounting-based adjustments will lower segment profit by more than $830 million for GE's beleaguered power business and reduce revenue by about $1 billion, implying a margin of around 5.5 percent before divestitures. Moody's has said that GE's perceived inability to restore margins in the power segment to at least 15 percent could be cause for a downgrade. That's increasingly looking like an impossible goal, not least because the power business in its current construct (including Alstom) didn't command margins that high at its peak, according to analysis from JPMorgan Chase & Co.'s Steve Tusa.
Stifel Financial Corp. analyst Rob McCarthy is targeting a margin of just 6.5 percent for the power business in 2018, and about 7 percent in 2019, albeit off a lower revenue base. I struggle to see how GE will double power margins in this environment, no matter how much management can cut costs.
In the chronicles of GE's unraveling, there have been numerous instances of people failing to realize there was a problem until it's too late, from management and the board to investors, analysts and the media. The longer the ratings firms fail to act -- especially after these restatements -- the more they reinforce the stereotype that they're a lagging indicator.
UPDATE: After the publication of this commentary, a GE spokesperson said the earnings restatements have no impact on the 2018 outlook.
GE books the earnings for these agreements in advance of collecting the associated cash. Questions have arisen as to whether its profitability assumptions were conservative enough.
This metric is based on backing out debt and Ebitda associated with the merger of GE's energy business with Baker Hughes, while accounting for the cash distributions from that subsidiary. On this basis, Moody's calculates GE leverage of 3.5X at the end of 2017 before accounting for the financial restatements. Moody's Ebitda calculations may not be exact comparisons to analysts' estimates.
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