There are always trade-offs when you invest, particularly if you venture into a turnaround situation like General Electric (NYSE: GE). Sure, the recovery potential could be huge, but there's always the chance that the company fails to pull out of the rut in which it finds itself. And with GE there are a lot of trouble spots to fix. Here's what you need to know before you buy General Electric stock.
What's been going on?
The problems at General Electric started before the 2007-to-2009 financial-led recession. Prior to that deep economic downturn, management, under Jack Welch, allowed the company's finance division to expand well beyond its original purpose of helping customers buy GE's industrial products. By the time the downturn hit, GE had its fingers in everything from insurance to mortgages.
Image source: Getty Images.
Finance can be a highly lucrative business, so it's easy to understand why management allowed the finance arm to keep growing. However, at the peak, it accounted for more than 50% of the company's profits. So when the recession unfolded there was no place for General Electric to hide -- its cyclical industrial businesses were facing their own issues. GE was forced to take a government bailout, sell assets, take write downs, and cut the dividend.
At first, it seemed like the steps it was taking to turn things around were working. It even made a couple of large acquisitions, one in the energy space and the other in the renewable power area (specifically wind turbines). However, both of those investments quickly faced headwinds and the company ousted its CEO, elevating an insider to the vacated post. Another round of write-offs, asset sales, and a dividend cut ensued. After roughly a year, the board decided that an even more radical change was needed and the CEO was again pushed out, this time to be replaced with an outsider who had previously helped to turn around Danaher. Although Danaher was a smaller industrial company, the hope was that his turnaround experience would help get GE back on track. Of course, the first step was more asset sales, write-offs, and yet another dividend cut.
A long road, with more to tread
The one thing that hasn't been noted specifically here is time. The troubles at GE started in the 2007-to-2009 time frame. The turnaround effort is still a work in progress more than a decade later. In fairness, GE isn't a small entity, and turning big ships takes time. However, there are still a lot of trouble spots to contend with here, and there's not much wiggle room left at this point.
For example, GE sold off a piece of its healthcare division to raise around $20 billion. That was much-needed cash and will go a long way to helping the company muddle through this long-running turnaround drama. So, in one sense, it was the right choice. However, healthcare is one of the company's best-performing divisions. In fact, it was the only division with positive segment margins, a non-GAAP measure the company uses to track performance, during the second quarter. But if GE is at the point where it needs to sell the crown jewels, investors should be concerned.
Then there's the finance arm. Although most of the division has been dismantled, GE is still on the hook for the costs of some long-term care insurance products. These policies have not performed as expected, and there's no way for investors to tell just how bad things could get. Further, the SEC is investigating GE around its accounting for these policies, amping up the risk even more. Meanwhile, GE also has a notable business financing airplanes, which is itself facing its own headwinds as airlines feel the impact of COVID-19 (more on this industry below).
To make matters worse, two of the company's four main divisions -- power and renewable energy -- have been struggling for several years. Getting them back on track will require a mixture of company efforts and an improvement in the end markets they serve. There's little GE can do but wait on the latter issue, and while it does these two divisions continue to bleed cash. Together they accounted for about half of second-quarter revenue.
And that's not the only headwind: With COVID-19 leading to a steep decline in air travel, GE's aviation division, which makes jet engines, is also struggling. GE's reported segment profit margin here fell to negative 15.5% in the second quarter, making it the worst-performing division in that three-month period. Once again, there's only so much GE can do to fix the problem, since it is end-market demand that's the main source of trouble. This division generated a bit more than 25% of the company's second-quarter revenue.
Be careful, very careful
If all of this sounds kind of ugly, well, it is. Conservative investors should probably stay on the sidelines until there are sustained signs of improvement. GE is probably only appropriate for aggressive investors willing to own turnaround stocks.
There's an old Wall Street saying that the best time to buy is when there's blood in the streets. GE looks like it's bleeding pretty badly right now -- the stock is back down to where it was during the 2007-to-2009 recession. The problem is that there are no signs on the horizon to suggest that things are likely to get better anytime soon. Buying GE today is something of a leap of faith. Only investors with very strong constitutions should make that jump.
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