Update on General Electric (GE)

On Friday (4/13), General Electric (GE) filed an 8-K that quantified the impact of adopting new accounting standards (and certain voluntary changes in accounting policies) on its previously reported results for 2016 and 2017.  In total, these changes reduce previously reported 2017 GAAP earnings by $2.79 billion or $0.32 per share and 2016 GAAP earnings by $1.23 billion or $0.15 per share.  The changes also reduce year-end 2017 assets by $8.7 billion and shareholders’ equity by $8.5 billion or $0.98 per share.

The greatest impact on GE’s prior year financials was from the adoption of Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers.  Adoption of this standard reduced GE’s 2017 GAAP earnings by $1.56 billion or $0.17 per share and 2016 GAAP earnings by $1.18 billion or $0.13 per share.  Those results were consistent with estimates given in GE’s 2017 10-K.  In addition, GE said that ASU 2014-09 adoption reduced its pre-2016 retained earnings by $4.24 billion (or by $0.45 per share, according to my calculations, using the year-end 2015 share count).

The adoption of this accounting standard relates primarily to contract assets associated with GE’s long-term service agreements as well as revenues booked in excess of billing for the construction of technically complex equipment (e.g. gas turbines and aircraft engines).  Under this approach, the assets booked by GE that is mostly offset by corresponding deferred income liabilities, both of which are amortized over time.

Several analysts have criticized GE’s use of contract receivables presumably because they feel that it resulted in overstated income.  Under the accounting standard, GE has dialed down its previous earnings and the carrying values of assets and liabilities.  In total, GE reduced year-end 2017 contract assets by $8.5 billion or nearly 30% and related inventories by $2.0 billion or about 9% of their carrying value.

Yet, GE said that the adoption of ASU 2014-09 mostly affects the timing of revenue recognition and the classification between revenues and costs.  The new standard does not impact cash or the economics of GE’s underlying customer contracts.  Consequently, GE will presumably earn back  the losses related to the adoption of ASU 2014-09 in future periods.

The adoption of ASU 2014-09 also resulted in a charge of $1.1 billion or $0.13 per share associated with recently adopted tax reform.  By reducing net deferred tax assets, the company presumably was reporting higher income for tax purposes (than for financial reporting purposes).  This $0.13 per share reduction is permanent, due to the now lower tax rate.

Besides ASU 2014-09, GE also recognized losses of about $0.02 per share in each of 2016 and 2017 related to the change in its accounting for certain inventories from last-in, first out (LIFO) to first in, first out (FIFO).  With the change, all of GE’s inventories will now use FIFO accounting.  The company said that it decided to make this change because all of the businesses previously utilizing LIFO are expected to be in a deflationary cost environment due to scale economies and expected future manufacturing efficiencies.  As a result, it sees no financial benefit from maintaining the LIFO accounting policy.

Besides these two policy changes, the company has adopted several other accounting standards that will mostly affect financial statement presentation.

GE pioneered the separation of non-service-related pension and other benefit costs in its non-GAAP reporting.  ASU 2017-07, Improving the Presentation of Net Periodic Postretirement Benefit Cost, will reflect this change on the income statement, but it will not change reported net income.

With the adoption of ASU 2016-18, Restricted Cash, GE will now include restricted cash in its definition of cash in the cash flow statement.  I believe that restricted cash was previously included in other assets and changes in restricted cash were reported in “All Other Investing Activities.”

With the adoption of ASU 2016-15, Classification of Certain Cash Receipts and Cash Payments, GE will reclassify $553 million of 2017 cash inflows from securitized receivables from operating activities to investing activities.  The company says that this will not impact reported 2017 industrial cash flows.

With the adoption of ASU 2016-16, Intra-Entity Transfers of Assets Other than Inventory, GE will no longer defer the tax impact of intra-entity transfers (i.e. between GE and GE Capital).  Adopted under the modified retrospective method, ASU 2016-16 will increase January 1, 2018 retained earnings by $464 million.

GE has also elected to move the “Other Income” out of total revenues to the section below total costs and expenses on its income statement.

Also on Friday (4/13), the Wall St. Journal reported that GE is exploring further spin-offs or merger transactions similar to Baker Hughes where it monetizes a part of its investment in a business and/or combines it with another industry player to create an entity with greater operating scale and market share.  It says that GE now views this approach as a more likely outcome for its Transportation business (rather than an outright sale).

The Journal also reported that GE was reviewing options for the remaining businesses within GE Capital, including a possible sale of the entire GE Capital portfolio.  It said that some analysts believe that GE Capital has zero equity value and that GE might have to write a check to sell off the business.

Although GE Capital has generated significant losses over the past three years and no free cash flow, excluding proceeds from the sale of discontinued operations.  its GE Capital Aircraft Services (GECAS) and Industrial Finance businesses have been consistently profitable.  Excluding impairment charges taken in 2017, its Energy Financial Services (EFS) business has been profitable.

Despite a substantial downsizing of the business over the past several years, GE Capital ended 2017 with $156.7 billion in assets, more than 40% of GE’s total consolidated assets.  Although GE has set its sights on primarily on becoming an industrial company (with vertical financing operations), it still has significant finance assets, outside of the verticals.  Yet, the company now classifies nearly all of GE Capital’s businesses, including most of the non-verticals, as part of its industrial operations.

Management has said that it will continue to pare back GE Capital’s assets, now by scaling down both its EFS and Industrial Finance businesses.  Over the years, GE has viewed its finance capabilities as a key differentiator, helping to generate sales for its industrial businesses.  Now, however, the company apparently believes that the potential benefit many higher sales does not outweigh the costs associated with extending credit.

So far, GE has said little about its legacy insurance operations, which incurred a large write-down in 2017 and will require an estimated cash equity infusion of $15 billion over the next five years.  I believe that investors would respond positively to a sale of these legacy insurance operations.  As the Journal hinted, it may even be worthwhile for GE to pay someone to take those (assets and) liabilities off its hands.

April 16, 2018

Stephen P. Percoco
Lark Research
839 Dewitt Street
Linden, New Jersey 07036
(908) 448-2246

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