The importance of GE's credit rating
Courtesy of John Hempton, Bronte Capital
The cover story in Barrons this week is on GE's dim prospects. I confess to being a very minor source for that story. I don't own GE – but there is a price below the current price where I would buy it.
That said, I think there is one last shoe to drop, and it is a doozy. And it wasn't covered in Andrew Bary's excellent article. That is that GE's credit rating – and hence its business – is under threat.
GE's best business (by far) is jet engines where it competes with Rolls Royce (in wide-bodied engines) and a Pratt & Whitney consortium in narrow bodied engines.
There is a new generation of engines (and planes) now – and the aviation business is booming. Boeing's stock price reflects that.
But GE is no longer the unequivocal engine leader. In wide-bodied (ie planes with two aisles) the current leader is the Airbus A350 powered by a Rolls Royce engine. It is the most fuel efficient long-haul plane on the market (measured in fuel cost per passenger-mile) and the engine is provided exclusively by GE's competitor. GE is playing catch-up – but will probably succeed with the Boeing 777x which (on paper anyway) will take the mantle as the world's most efficient plane.
In narrow-bodied the GE may still be the leader but Pratt & Whitney has caught up a great deal. Picking the competing engines apart is difficult (although at the moment the Pratt & Whitney competition has problems with a knife-edge seal). [I know serious aviation nerds who think the P&W engine is a better product with better prospects – although I think that is a minority view.]
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The jet-engine business is threatened by GE's current worries. You see jet engines (especially wide-bodied jet engines) are sold with very long-term maintenance contracts. If I order a 777x now it will be a couple of years before the first delivery, maybe 10 years before my delivery and expect to be flying the plane for another 20-25 years after that. I may be ordering 10 planes in which case my last delivery may be 15 years away and I expect to fly that plane for a further 25 years.
Whoever buys this plane needs to be confident that GE will be around and solvent in 40 years to actually do the maintenance. The GE aviation business is more credit sensitive than almost any business I can think of.
And that is a problem because as Andrew Bary notes GE's debt is already trading as if the credit rating is BBB+, and if you are entering very long maintenance agreements BBB+ is simply not good enough.
If Ahmed bin Saeed Al Maktoum or Akbar Al Baker gets jittery re GE's credit rating then it will threaten GE's ability to sell engines or even Boeing's ability to sell planes (on which GE is the monopoly engine provider).
Who are these guys you have never heard of? Well Ahmed bin Saeed is the CEO of Emirates airline and Akbar Al Baker is the CEO of Qatar airlines. These are the biggest buyers of long-haul jets in the world. They are GE's most important customers.
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GE is, I think, a rationally run business – meaning management run it to management's incentives. In the old days that was to buy stock and keep the price high (options) but now it is clearly just for business survival.
And business survival requires that GE maintain its credit rating.
That is why there will be an equity raise.
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There are plenty who argue that GE should be broken up. I am not averse to the possibility but it is much harder than it looks. GE has lots of obligations including over 100 billion in debt and 30 billion in pension shortfalls. It also has guaranteed a few (painful) insurance obligations.
If you break up GE those obligations have to go somewhere. And debt holders or the Pension Benefit Guarantee Corporation is not going to accept them being placed against GE's troubled businesses (such as power systems). And Ahmed bin Saeed isn't going to accept them being placed against the aviation business.
So in a break-up a lot of capital needs to be raised. Probably in excess of 50 billion.
Bluntly I do not think a break-up is realistic. You could get away with under half the raise if you don't break it up. And maybe you could just sell some businesses to strengthen the balance sheet and get away without a raise.
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Rolls Royce went through this. There was a period where Rolls was problematic – and if you looked at the balance sheet you would have immediately rated it A+. But even then A+ was barely enough – even the threat of a downgrade and Rolls would have had to raise capital to protect their business.
Rolls never raised equity – but it was touch-and-go.
GE is far more problematic than Rolls at the nadir – simply because there are far more obligations on GE's balance sheet.
I reckon an equity raise is likely. I don't know why they didn't cut the dividend in its entirety (except maybe that wasn't enough). It may be that 20 billion in asset sales is enough – but I have my doubts. I think they will need more to keep the customers satisfied.
Ahmed bin Saeed Al Maktoum, this one is up to you.
John
POST SCRIPT: I have been asked several times how GE got into this trouble. Here is my very quick summary.
a). GE was left hyped up and overly dependent on finance income and accounting tricks under Welch (who I think is the main culprit here),
b). Immelt did not defuse all the unexploded Wendt bombs anything like fast enough. GE would have gone bust on the Welch trajectory, and Immelt got it off the Wendt trajectory, but not far enough off the Wendt trajectory, and
c). Both Wendt and Immelt behaved as if their body odour was perfume. They believed their own hype and bought back stock and stock and more stock. Total shares repurchased were over 100 billion dollars. Just 30 billion of that money now would solve the credit rating problems.
d). Power systems which was once perhaps the golden business fell on hard times. Solar is now cheaper than coal or gas. Renewables are cheap. This is a problem if you are the biggest capital equipment sellers to the old tech. This was exacerbated by spending 10 billion on Alstom just as it all fell apart. Immelt doubled down on dying technology.
The 20 year accounts are here.
