In April 2015, partially in response to the regulatory restrictions that accompanied GE Capital’s designation as a systemically important financial institution by the Financial Stability Oversight Council, GE adopted the GE Capital Exit Plan, under which it planned to reduce the size and scope of its financial services operations through the sale of most of GE Capital’s assets and focus on growing its industrial businesses. The plan was originally intended to be completed over two years. GE intended to keep most of its vertical financing businesses, including GE Capital Aviation Services (GECAS), Energy Financial Services (EFS) and its Healthcare Equipment Finance business, which directly support its industrial businesses.
In conjunction with the Exit Plan, GE merged with GE Capital to assure Capital’s compliance with its debt covenants as it exited the non-vertical assets and businesses. In the merger, it created an intermediate holding company for GE Capital’s businesses and assumed GE Capital’s debt. GE also amended its financial support agreement with GE Capital to provide a full and unconditional guarantee of principal and interest on all of GE Capital’s outstanding tradable debt and commercial paper. At year-end 2015, GE reported $85.1 billion of assumed debt and $85.8 billion guaranteed debt.
Since 2015, as GE Capital has sold assets, the amount of debt assumed and guaranteed by GE has declined. At the end of 2019, GE carried $31.4 billion of assumed debt on its industrial balance sheet and its guarantee applied to $34.7 billion of GE Capital’s debt. The amount of assumed and guaranteed debt will be reduced by at least $12 billion this year, as GE Capital repays maturing debt mostly from the proceeds of repayment by GE of an outstanding $12.2 billion intercompany loan. GE should therefore end 2020 with about $19 billion of assumed and $23 billion of guaranteed GE Capital debt.
Even though this assumed debt is carried on GE Industrial’s balance sheet, GE states clearly in its financial statements that it considers this debt to be an obligation of GE Capital. As noted in my earlier post, GE’s calculation of (non-GAAP) GE Industrial adjusted borrowings does not include this assumed debt. Consequently, I will follow the company’s designation and consider this debt in my valuation of GE Capital.
Current Status of GE Capital and the Exit Plan. GE Capital has made substantial progress in reducing its risk profile since adopting the Exit Plan. GE’s ending net investment in GE Capital, a measure of capital employed excluding liquidity, has declined from $362 billion in 2014 to an estimated $51 billion in 2019. At this point, there appears to be little that GE Capital has to sell. GE Capital’s remaining businesses include GECAS, EFS (which supports GE’s Power and Renewable Energy businesses), a much scaled down Industrial Finance, Working Capital Solutions (which factors trade receivables generated by GE) and the legacy Insurance runoff operations. Healthcare Finance was rolled into GE Healthcare in 2019. At year-end 2019, less than $4 billion of GE Capital’s assets were included in discontinued operations and $2.5 billion of assets and businesses were held for sale.
It seems unlikely now that GE will formally announce an end to the GE Capital Exit Plan, even though it does appear that the Plan has ended. Management forecasts that GE Capital’s assets will likely grow slightly over the next couple of years.
GE Capital has been viewed with fear and suspicion by investors ever since GE shocked the Street by announcing a $6.2 billion charge against its legacy insurance operations in early 2018. Besides the insurance fiasco, analysts have been critical about GE’s practice of selling its trade receivables to GE Capital, which artificially raises GE Industrial’s cash flow from operating activities. Investors have also been wary about the risk of other downside surprises, especially in insurance, even though management has improved Capital’s financial disclosures and demonstrated progress both in addressing the risk of additional capital shortfalls in its legacy insurance operations and in reducing GE’s reliance on factored receivables. Ongoing uncertainty about GE Capital’s prospects has been a weight on GE’s share price.
Recent Historical Results. GE Capital reported net earnings attributable to the company before preferred dividends of $122 million in 2019, its first profit in five years. Its losses have narrowed sharply since the early years of the GE Capital Exit plan. Profits from GECAS and other GE Capital operations have been offset in recent years by losses in insurance and interest costs on excess debt (defined as debt previously allocated to assets that have been sold or “stranded” debt and debt not allocated to GE Capital’s operating segments). Still, Capital has been operating near breakeven while maintaining its focus on paring debt.
Since 2017, GE Capital has reduced total borrowings by 31% from $100.5 billion to $69.6 billion. Net debt, after deducting the intercompany loan to GE and adding in the non-recourse borrowings of securitization entities, is down 38% to $59 billion. As a result of the decline in debt and GE’s $4 billion capital contribution in 2019, GE Capital’s debt-to-equity ratio has dropped to 3.9 times in 2019 from 7.1 times in 2017. Management expects to keep Capital’s debt-to-equity ratio below 4.0 times going forward.
GE Capital’s Outlook. GE Capital has become simpler and more focused, while continuing to support the industrial businesses and reduce risks. Its core business platforms are GECAS, EFS and North American Life and Health (NALH), the legacy runoff insurance business. (Industrial Finance and Working Capital Solutions are therefore non-core and presumably candidates for further downsizing.)
In its 2020 Outlook presentation, GE Capital has forecast an adjusted loss from continuing operations of $300-$500 million in 2020, a reversal from 2019’s $139 million of adjusted earnings. Management said that the decline will be driven by lower gains on asset sales and lower base earnings as a result of asset sales (presumably those that were completed in 2019). It expects GECAS’s segment earnings to be between 900 million and $1 billion, down from $1.03 billion in 2019, as a result of the sale of PK AirFinance in the 2019 fourth quarter. It did not provide specific guidance for Capital’s other segments.
Management did not voice any expectations of further asset sales. It expects that Capital’s total assets will increase by about 3% in 2020 to $105 billion and by a modest amount again in 2021. The 2020 increase will be driven by modest growth at GECAS and EFS and also by GE’s contribution of an estimated $2 billion to fund insurance’s capital obligations, the proceeds of which will be placed in its investment portfolio.
Management expects that Capital will achieve breakeven results in 2021, mostly as a result of the transfer of $460 million in annual preferred dividend payment obligations to GE and lower interest expense. GE Capital’s Series D preferred stock, whose terms mirror GE’s publicly traded Series D preferred, converts mandatorily into GE Capital common stock in January 2021. Consequently, Capital will no longer be obligated to fund the dividend payment on the GE Series D preferred. The annual savings of $460 million alone should bring GE Capital to within striking distance of breakeven results.
Worth the Risk? GE Capital enabled $6 billion of industrial orders in 2019, mostly through Energy Financial Services, and expects to facilitate more than $5 billion of orders in 2020. Yet, the 2019 facilitated orders represents only 6.6% of GE Industrial’s total orders and 13.3% of its equipment orders. While not insignificant, it is questionable whether the support provided by GE Capital to GE Industrial today is significant enough to justify the capital invested and the associated risks. Would GE have lost all of those orders without the help of GE Capital? In the past, GE Capital was able to underwrite successfully many of the financings associated with orders that would not be approved by other financial institutions because it was better able to assess the business or project risks; but except perhaps for GECAS does that still hold true today? If other financial services firms are unwilling to underwrite those orders at a cost to the customer that greenlights those sales, isn’t GE Capital clearly exposing itself to excessive risks? Should GE Capital continue to utilize $50 billion in capital indefinitely, if it cannot earn a return on it?
These are questions that GE’s Board of Directors have almost certainly considered. At this time, Capital’s earnings are burdened by excess debt, so perhaps it will become profitable enough over time to justify the continued investment. If GE would prefer to exit GE Capital, the Board’s options for taking additional actions to downsize it now may be limited by the excess debt. Similarly, GE probably cannot simply walk away from other GE Capital commitments, including its loss-making runoff insurance business. It may also be hard for GE to find buyers today for its remaining core operations or a single buyer for all of GE Capital. As the excess debt continues to decline, GE will be better positioned to consider other options for disposing of the remaining business, if that is what it wants to do.
Valuation. In the table below, I break down of Capital’s actual 2019 and projected 2020 segment earnings and reconcile them to adjusted earnings (loss) from continuing operations, a non-GAAP measure upon which management’s guidance is based. The table also offers a sum-of-the parts valuation for GE Capital using simplified assumptions.
My 2020 projections for segment earnings reconcile to GE Capital’s adjusted earnings (loss) from continuing operations at the midpoint of management’s $300-$500 million range. My forecast of $950 million in segment earnings for GECAS is within management’s guidance range. I project that earnings for EFS and IF & WCS will be down in 2020 and that insurance will have breakeven results, an improvement from 2019’s $611 million loss. I also assume that the loss for the catch-all “Other Continuing Operations” segment will widen to $1.6 billion in 2020. The total of the projected earnings and losses for each segment equate to a $400 million loss from continuing operations, which is the midpoint of the guidance range.
Since the gain from the sale of PK AirFinance was only $50 million and management’s guidance anticipates that GECAS’s earnings will be flat to down $100 million, it is difficult to explain the full $500 million negative swing in projected 2020 adjusted earnings. Without further guidance, it is also difficult to allocate the anticipated earnings decline among the various remaining GECAS segments. For example, I have no basis for assuming another premium deficiency charge for Insurance in 2020, given management’s positive assertions about its claims experience. So management’s explanation for the swing in profitability – lower gains on sale and lower base earnings – does not seem complete or maybe management is being conservative in its outlook. As it turns out, my valuations for the Insurance and Other Continuing Operations are not earnings based, which (for now at least) sidesteps the issue.
With a focus on valuation, let’s look at each of the segments in more detail.
GE Capital Aviation Services (GECAS). GECAS is a leading aircraft finance company with more than 50 years of experience. At the end of 2019, it owned, serviced or had on order more than 1,700 aircraft for 225 customers in 75 countries. The business has a well-established track record of navigating successfully through the business cycles. In the past, it has been able to keep virtually all of its fleet in the air (on lease or on loan) even through the worst of the airline industry downturns.
Using the 2019 reported figures, GECAS looks quite similar to AerCap Holdings, N.V. (NYSE:AER), also a leading aircraft leasing company and a major GECAS competitor. AerCap’s equity market value has fallen 63% year-to-date (through March 31), largely due to the concern that its lessees and borrowers, who are primarily the global airlines, will stop making their lease and debt payments. With the drop in its equity value, its trailing twelve-month P/E ratio has fallen from just under 8.0 times at the beginning of the year to about 3.0 times.
Applying those same P/E multiples to GECAS’s segment earnings yields an equity valuation of $8.2 billion at year-end 2019 and only $2.6 billion for at March 31, 2020 (using projected 2020 segment earnings). Assuming that its leverage is comparable to AER’s, GECAS’s $38 billion of assets should support roughly $30.0 billion of debt, which would give GECAS an enterprise value of $38.2 billion at 31-Dec-19 and $32.6 billion at 31-Mar-20.
(Throughout this analysis, I use the trailing 12-month P/E ratios for valuation purposes, even though my 2020 valuations are based on projected 2020 earnings. As it turns out, projected earnings for many financial service companies, including those used as comparables here, are still mostly unchanged so far and flat with 2019 reported earnings; so the forward multiples are still reasonably close to the trailing multiples. Readers should also note that GE Capital’s segment earnings include interest and other financial charges, income tax expense, non-operating benefit costs and preferred stock dividends (i.e. they are equivalent to net income), which supports my use of comparable P/E ratios to value the segments.)
Energy Financial Services (EFS). My projections anticipate that Energy Financial Services segment earnings will decline from $121 million in 2019 to $100 million in 2020. CIT Corp (NYSE:CIT), which looks like a reasonable comp, was trading at around 10 times at trailing 12-month earnings at year-end 2019 and only 4.0 times earnings today. Using those same multiples, I estimate that EFS’s valuation was around $1.2 billion at the end of 2019 and only $400 million at 31-Mar-20.
Industrial Finance (IF) and Working Capital Solutions (WCS). IF and WCS produced $234 million of segment earnings in 2019. My projections anticipate $150 million of segment earnings at 2020. Applying the CIT multiples to their segment earnings yields equity values of $2.3 billion at 31-Dec-19 and $600 million at 31-Mar-20.
Insurance. In early 2018, GE announced a $6.2 billion charge against 2017 results related to its legacy insurance operations, mostly from the reinsurance of long-tail long-term care policies whose premiums did not compensate sufficiently for the significant increase in life expectancy that has occurred. Along with the charge, GE said that Capital would make $14.5 billion of statutory reserve contributions over seven years, under a deal struck with its primary regulator. Since then, it has made $7.4 billion of contributions, including $3.5 billion in 2018, $1.9 billion in 2019 and $2.0 billion in the 2020 first quarter. That leaves roughly $7.1 billion of expected capital contributions through 2024.
In the 2019 third quarter, based upon its annual premium deficiency testing, GE recognized an additional charge of $972 million pre-tax ($768 million after-tax), mostly due to a decline in the discount rate that was required because of the general decline in interest rates. Importantly, both incurred and paid claims declined in 2019 and management said that claim experience is tracking close to the new claim curves established in 2017. If that continues, Capital should not have to make additional capital contributions beyond its current commitment. If its claims experience improves or if it is able to continue to get its primary insurer customers to continue to raise premium rates beyond what it has already built into its capital plan with regulators, it may eventually be able to recover some of the $14.5 billion in past and future capital contributions.
With the recent volatility in the financial markets, it is likely that NALH has suffered losses on its investments, especially since its recently hired investment managers have been given a mandate to seek higher returns more aggressively. Today, those are likely unrealized losses, so the key question, which almost certainly will depend upon a rebound in the financial markets, is whether those losses will be realized. On the flip side, COVID-19 may be a boon to long-term care insurers and reinsurers like NALH because it might reduce the pool of potential claimants.
My 2020 projections assume breakeven results for NALH. For valuation purposes, I assume that it has a negative value, equal to the net present value (discounted at a 10% rate) of the capital that GE is required to contribute to meet NALH’s statutory reserve requirements over the next four years. With the estimated $2 billion capital contribution that GE made in the 2020 first quarter, its remaining obligation is currently $7.1 billion. Going forward, GE will probably continue to contribute the capital required for NALH to meet its statutory capital reserve obligations.
GE’s capital contributions are driven by statutory cash flow testing practices that incorporate provisions for adverse deviations under moderately adverse conditions. Under GAAP accounting, GE believes that it has reserved adequately for expected future losses on its insurance books; but the insurance regulators require more capital to cover losses under more adverse assumptions. If GE’s GAAP assumptions prove to be correct, it will be able eventually to reclaim the $14.5 billion of required capital contributions. However, it probably will not be able to begin to do so until its actual claims experience moves much farther along the actuarial claim curves to convince regulators that there is a sufficiently high probability that the future claims experience is unlikely to deviate meaningfully from those original assumptions.
If GE contributes the remaining $7.1 billion through 2024 and does not reclaim any of these contributions in the future, the net present value of its contributions, at a 10% discount rate is roughly $6 billion. NALH would therefore have a value of negative $6 billion at March 31, 2020.
On the other hand, if NALH recovers all of the $14.5 billion in contributed capital at the rate of $2 billion per year from 2026 to 2033, its net present value would be positive $800 million.
For valuation purposes, I am assuming NALH’s value to be negative $6 billion under the assumption that it will not recover any of its capital contributions. This, I believe, is a conservative assumption, even though some might argue that investment losses or adverse deviations greater than those assumed in its regulatory settlement could require GE to increase its capital contributions in the future.
Other Continuing Operations. At this time, this catch-all segment figures prominently in my valuation of GE Capital, but it is also difficult to analyze. In 2019, the segment reported $22 billion of assets at year-end, no revenues and a segment loss of $1.3 billion. GE says that these operations primarily comprise excess interest costs on stranded debt (i.e. debt previously allocated to assets that have been sold), interest costs on debt not allocated to the other GE Capital segments and preferred stock dividend costs.
Since this segment probably also includes the corporate or headquarters operations of GE Capital, it may have other expenses that figure into segment results and its $22 billion of assets may include cash, deferred income tax assets, assets held-for-sale and other assets.
Based upon my analysis, I believe that the $31.4 billion of debt assumed by GE roughly equates to the total of stranded and unallocated debt. I have reached this conclusion because it fits with a reasonable allocation of all of GE Capital’s debt to its segments. Of the total $69.6 billion of GE Capital debt outstanding at the end of 2019, I estimate that about $30 billion is allocated to GECAS, which had 2019 segment assets of $38 billion. (By comparison, AerCap had $43.7 billion of assets and $29.7 billion of debt at the end of 2019). If my estimates are correct, that would leave $8.2 billion of debt for EFS, IF and WCS, whose 2019 combined assets totaled $10.8 billion.
Assuming an average interest rate of 4%, the $31.4 billion of debt that I have allocated to Other Continuing Operations would generate annual interest expense of $1.26 billion. As noted above, the segment posted a 2019 loss of $1.3 billion, of which $460 million was preferred dividends. That would seem to leave room for only $840 million of interest expense.
However, if I also assume that the $12.2 billion intercompany loan to GE is included in this segment and if GE pays a comparable 4% interest rate on that debt, the segment would receive $0.49 billion of annual interest income that partially offsets the estimated $1.26 billion of interest expense on the $31.4 billion of GE assumed debt. The net interest expense would therefore be about $770 million, which is pretty close to the remaining $840 million of remaining segment loss, excluding the $460 million preferred dividend.
My conclusions seem to fit well with GE’s limited financial disclosures, but this is still just a guess and there are related issues that are not easy to reconcile. For example, my analysis also does not leave much room for corporate expenses or the 2019 recorded income tax benefit.
GE says that it expects to repay all of the stranded debt in 2020 and gradually pay down the unallocated debt over time. It also says that it assigns interest expense on the debt allocated to other segments at a rate below what it actually pays, which suggests that it allocates more debt to the segments and less to Other Continuing Operations than my estimate would imply. (If the segments are able to support more debt at the lower current market rates, it might open the door to future financings that could further reduce GE’s exposure. For example, GECAS could securitize some of its aircraft loans and leases and use the proceeds to repay debt assumed and guaranteed by GE.)
The assessment of stranded and unallocated debt is important for valuation purposes. With a $1.3 billion segment loss, Other Continuing Operations has a negative equity value. If the segment does indeed hold the $31.4 billion of GE Capital debt assumed by GE, offset partially by the $12.2 billion intercompany loan to GE, that would represent a negative net equity value of $19.2 billion (actually $19.14 billion). The segment’s value would be negative because it has no income to service the debt. By that same reasoning, the $5.7 billion liquidation preference of the Series D preferred stock should also be counted as negative for segment valuation purposes.
Having completed the sale of BioPharma on March 31st, GE will repay the $12.2 billion intercompany loan and GE Capital will use the proceeds to repay a comparable amount of maturing debt. If the Other Continuing Operations segment holds both, the two will net out upon repayment, leaving the net amount unchanged, even though the outstanding GE assumed debt will be reduced by $12.2 billion to $19.2 billion. At year-end 2020, I also assume that the Series D mandatorily convertible preferred stock goes away, even though it technically does not convert into GE Capital common equity until January 21, 2021.
Potentially offsetting the net debt of $19.2 billion is the $18.8 billion of cash on the balance sheet. A portion of this cash, perhaps as high as 75%, might possibly be considered cash that is not needed to run the business and so it might be available to pay down outstanding debt. (75% was the percentage used by GE in its calculation of GE Industrial’s excess cash.)
Still, GE Capital (to my knowledge) has no financing availability under any credit facilities at this time, so it is keeping this cash to meet its liquidity, financing and operating needs, including paying off maturing debt and addressing any cash requirements in its businesses. Eventually, after GE Capital returns to the financial markets, as it expects to do in 2021, it may obtain a bank credit line, which would presumably then free up the cash to pay down more of the debt. Thus, some of this cash could be an offset to debt in the future, but for now, I am not including it in my valuation analysis.
In addition, my valuation does not consider the potential cash that could be raised from the sale of assets and businesses currently classified as held for sale and from the sale of discontinued operations. At December 31, 2019, GE Capital has assets held for sale of $2.3 billion, businesses held for sale of $0.2 billion and net assets of discontinued operations of $3.8 billion.
Summing It Up. My analysis indicates that GE Capital had a negative value of $20.4 billion at the end of 2019, due entirely to my estimate of its stranded and unallocated debt. That valuation remains essentially unchanged at negative $21.3 billion at March 31, 2020, in large part due to the recent decline in equity values.
The valuation is conservative for several reasons:
It utilizes the current low valuations for financial services stocks, following the big market sell-off in March. If the negative impact of COVID-19 is contained within the next few months, those valuations should recover.
I value GE Capital’s legacy insurance operations at negative $6 billion, which is equal to the net present value of the remaining required capital contributions. If claims continue to track along the recast experience curves, NALH could eventually recover part or all of the capital contributions.
I also assess a net negative value of $19.1 billion to Capital’s Other Continuing Operations segment, equivalent to the projected outstanding debt assumed by GE. If GE Capital is able eventually to free up its $18.8 billion of cash, cash equivalents and restricted cash, much of it would be available to reduce the remaining outstanding GE assumed debt. If 75% of that cash were available today, my valuation estimate for GE Capital would improve from negative $21.3 billion to negative $7.2 billion.
Furthermore, if Capital can sell its assets and businesses held for sale and net assets of discontinued operations at their year-end carrying values, it would raise another $6.3 billion that could be used to pay down debt.
Despite my net negative equity valuation assessment, I believe that GE Capital will not require any additional capital contributions from GE (beyond those scheduled for insurance). Over time, GE Capital should be able to whittle away at the remaining outstanding debt assumed by GE and could accelerate the paydowns with available cash on hand after it returns to the capital markets for financing in 2021.
Limited Parent Support Likely Going Forward. Although GE Capital is seen by many as a drain on GE’s resources, it has throughout its history been a source of cash for GE, mostly through dividend payments. Even in recent years, GE Capital has been a net provider of cash to GE through its extension of intercompany loans. While GE has made capital contributions of $4 billion to GE Capital in 2019 and an estimated $2.0 billion in 2020, it has also received about $2.0 billion annually over the past three years by selling receivables to GE.
On balance, as long as the global economy holds up (or the recession is short-lived), GE Capital should be able to manage its operations and reduce its remaining GE assumed debt obligations gradually over time. With a recovery in the financial markets, both debt and equity, it should be able to begin tapping the debt markets again in 2021 as planned to refinance future maturing debt issues. Its valuation deficit should be reduced from debt repayments and as the equity valuations of its remaining core businesses rebound, especially GECAS. Although I conclude that GE Capital has a negative value today, it is on a path that should allow its value to recover to breakeven or better over the next couple of years.
Other Posts in this “Deep Dive on GE” series:
The 2020 Outlook for Its Businesses (March 31, 2020)
Consolidated Enterprise Valuation (March 31, 2020)
Projected 2020 Consolidated Results (March 31, 2020)
Sum-of-the-Parts Valuation (April 5, 2020)
April 3, 2020
Stephen P. Percoco
839 Dewitt Street
Linden, New Jersey 07036
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