General Electric (NYSE: GE) stock's post-earnings rally got cut short last week after Fitch revised the company's credit outlook to negative from stable. That means the credit rating agency is likely to lower GE's rating from its current level of BBB+ in the coming months. This development comes just three months after Fitch cut the company's credit rating by two notches, from A to BBB+. The other two major credit rating agencies made similar ratings cuts last fall.
While Fitch could potentially change course, it is likely to go ahead and downgrade GE's credit rating again sometime this year. There's a good chance that Moody's and S&P will follow suit. Yet this shouldn't be of too much concern for GE shareholders -- at least not yet.
GE had a plan
Last June, GE executives laid out what seemed like a sensible plan to dramatically reduce the company's leverage by 2020. Management identified sources of cash totaling $60 billion that it could use to shore up GE Capital's balance sheet and reduce the core industrial operations' net debt by $25 billion.
The biggest chunk of debt reduction was to come from loading up GE's healthcare business with $18 billion of debt and pension liabilities, selling 20% of the business through an IPO and spinning off the rest to shareholders .
Various smaller divestitures were expected to yield after-tax proceeds of $10 billion. General Electric also planned to sell down its stake in Baker Hughes, a GE Company (NYSE: BHGE) over time. As of last June, the Baker Hughes stake was worth more than $23 billion. Lastly, GE expected to produce a modest amount of free cash flow above and beyond its dividend.
Since June, GE has accelerated the sale of its Baker Hughes stake. It slashed its dividend to save nearly $4 billion a year beginning in 2019. It has changed the terms of a deal to combine its rail operations with Wabtec such that it will receive an additional $2 billion of stock that it can monetize. (Those shares were previously supposed to be distributed to GE shareholders.) Finally, GE now plans to sell up to 49.9% of its healthcare business to outside investors, not just 20%.
Despite all of these moves designed to bolster its balance sheet, GE is no longer confident that it will meet its leverage target by the end of 2020.
Plunging profitability is the main challenge
There are several reasons why GE is having trouble shoring up its balance sheet. For example, it ended 2018 with about $55 billion of net debt in its industrial operations -- $5 billion above its June projection -- despite receiving approximately $3.6 billion from selling Baker Hughes stock that it had been planning to hold until at least 2019 as of June.
A sharp reversal in interest rates and a late-2018 stock market swoon contributed to this missed target by offsetting some of the progress GE had made in the first half of 2018 toward reducing its pension deficit. The company also had to spend more than $3 billion last fall after Alstom exercised its option to sell its interests in three joint ventures to GE. Finally, General Electric missed its original free cash flow target for the year by about $2 billion.
The late-2018 plunge in oil prices also knocked Baker Hughes' stock price down by about 30%, so GE won't get as much money from selling its shares in the company.
Yet the drastic cut to General Electric's dividend and the increased proceeds from its healthcare and transportation divestitures will more than offset these headwinds. The underlying problem is the rapid erosion of GE's profitability, because leverage is measured by comparing debt to earnings before interest, taxes, depreciation, and amortization.
Indeed, GE's power and renewable energy segments -- two of the three main businesses that will remain with the company going forward -- posted a combined segment loss of $521 million last year compared with a combined profit of $2.5 billion a year earlier. Management doesn't expect an immediate recovery in either business. As a result, even if it reduces its industrial net debt to $25 billion as planned, GE probably won't be able to reach its leverage target and regain an A-level credit rating by the end of 2020.
This is a temporary problem
The good news for investors is that while GE faces near-term earnings pressure, its earnings power could rebound quickly after 2020. First, the lucrative GE Aviation business earned $6.5 billion last year and is primed for strong profit growth over the next decade as the massive installed base of GE and CFM engines drives big increases in high-margin service revenue.
Second, new CEO Larry Culp is moving aggressively to fix the power and renewable energy units. Most notably, he is cutting layers of management at the corporate headquarters and at both divisions to reduce costs and improve decision-making. The results won't be instantaneous, but by 2021, both businesses should be on the road to health.
For the next year or two, General Electric will continue to have weak credit metrics, so further downgrades of its credit rating are likely. But if its rating falls by only one or two notches, GE will remain in investment-grade territory -- which is critical for maintaining access to the capital markets.
By 2021, GE's results should show clear signs of a profit rebound, leading to better credit metrics and paving the way for ratings upgrades. As long as the company maintains its investment-grade status and makes progress on reducing its debt and pension liabilities over the next two years, investors shouldn't panic if its credit rating moves a little lower in 2019 and 2020.
10 stocks we like better than General Electric
When investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor , has quadrupled the market.*
David and Tom just revealed what they believe are the 10 best stocks for investors to buy right now... and General Electric wasn't one of them! That's right -- they think these 10 stocks are even better buys.
*Stock Advisor returns as of January 31, 2019
Adam Levine-Weinberg owns shares of General Electric. The Motley Fool owns shares of and recommends Westinghouse Air Brake Technologies. The Motley Fool owns shares of Moody's. The Motley Fool has a disclosure policy .