General Electric Co (GE US) (“GE” or the “Company”) will be implementing multiple changes to its accounting policies in 2018, which will have a significant impact on reported cash flows from operations and reported earnings. Some accounting policies, such as those affecting cash flows will be implemented prospectively, whereas others will be applied retrospectively to allow investors the ability to compare trends over time. Upcoming changes project a picture of both heightened volatility in earnings, and lower cash flows from operations. Investors like neither. In ANTYA’s view, together the two foreshadow a compression in enterprise value multiple for GE implying that the company is on track to deliver a single digit stock price in the latter half of 2018.
In Part 1 we highlighted multiple challenges facing GE in 2018 and 2019. Adoption of new accounting standards is another one of those wrinkles that will throw investors off-balance. ANTYA maintains its view that given shrinking industrial operations, GE Capital’s inability to pay dividends to the company for the foreseeable future, and impending accounting changes to securitisation conduits which will reallocate industrial cash flow recognition from operations into investing, GE will be hard-pressed to generate meaningful free cash flow growth till 2020.
No wonder, on its Q4-17 analyst call, John Flannery the Chairman and CEO of GE said, “…. As we go into 2018 for our pay structure for the teams, our incentive structures for the team, as we said before, we had numerous incentives before. We have two in 2018. One of those is free cash flow. So the Company is focused and incentivised around cash flow.”
In our view, embracing free cash flow as a performance measure is driven more by necessity than a directional change, because prescriptive accounting policies proposed by FASB and adopted by the company, constrict earnings management.
The following sections make liberal use of GE’s annual and quarterly disclosures. Material sourced from GE is in italics followed by ANTYA’s explanatory comments.
BACKGROUND
In May 2014, the [Financial Accounting Standards Board] FASB issued a new comprehensive set of revenue recognition principles (ASU No. 2014-09, Revenue from Contracts with Customers) that supersedes most existing U.S. GAAP revenue recognition guidance (including ASC 605-35, Revenue Recognition – Construction-Type and Production-Type Contracts). The new standard will become effective for annual reporting periods beginning after December 15, 2017.
GE will adopt the standard on January 1, 2018, [and] will apply it retrospectively to all periods presented.
ANTYA View: Understanding the reasons behind GE’s choice to adopt a retrospective adoption is essential because GE’s business involves both production and service type contracts in its various divisions. As highlighted later, in our view and based on the company’s disclosures, this helps GE show better earnings growth down the road.
TRANSITION METHOD FOR APPLYING THE NEW STANDARD
As per FASB, companies can use either a full retrospective or modified retrospective method to adopt the standard. Under the full retrospective method, all periods presented will be updated upon adoption to conform to the new standard and a cumulative adjustment for effects on periods prior to 2016 will be recorded to retained earnings as of January 1, 2016. Under the modified retrospective approach, prior periods are not updated to be presented on an accounting basis that is consistent with 2018. Rather, a cumulative adjustment for effects of applying the new standard to periods prior to 2018 is recorded to retained earnings as of January 1, 2018. Because only 2018 revenues reflect application of the new standard, incremental disclosures are required to present the 2018 revenues under the prior standard.
ANTYA View: Again, this is important, because GE’s choice to apply it retrospectively can be considered an earnings management technique because retrospective application will improve the optics surrounding current and prospective EPS.
CHANGE IN TIMING AND PRESENTATION, NO IMPACT TO CASH OR ECONOMICS
The new standard requires companies to identify contractual performance obligations and determine whether revenue should be recognized at a point in time or over time based on when control of goods and services transfer to a customer. As a result, significant changes are expected in:
- timing of revenue recognition, and
- changes in classification between revenue and costs.
The effect of applying the new guidance to our [GE’s] existing book of contracts will result in lower reported earnings in 2018 (and comparative periods previously reported) and in the early years after adoption. However, we expect to experience an increase in reported earnings, on that existing book of contracts, as they mature. The new standard will provide for a better alignment of cash and earnings for the affected long-term customer contracts and we expect that it will enhance comparability across industry peers.
ANTYA View: The new standard automatically attempts to align cash and earnings, and hence it should not be surprising that management wants to adopt free cash flow as one of its two metrics for performance assessment. Furthermore, since the new accounting standard is expected to make reported earnings on the existing book of contracts better, retrospective application improves longer-term optics on the company. As we move forward, year on year comparison will look better, whereas the detrimental impact of retrospective application would be absorbed in 2016, 2017 and 2018. In the current year, investors have already discounted GE’s prospects. Down the road, better earnings for GE industrial could be sourced from this accounting policy change rather than any significant improvement in underlying operations. Given the slowdown in power and oil & gas markets, the existing book of contracts will play a more prominent role in delivering EPS growth, compared to a growing book of new business under new rules.
SPECIFIC EFFECT ON GE BUSINESSES
Power and Aviation Service Agreements – For our [GE’s] long-term product service agreements, primarily in our Power and Aviation businesses, we expect to continue to recognize revenue based on costs incurred plus an estimated margin rate (over time model). However, the new standard provides prescriptive guidance tied to several factors for determining what constitutes the proper scope of a customer contract for accounting purposes. These factors include optional purchases, contract modifications, and termination clauses. For example, under the new standard contract modifications will be accounted for prospectively by recognizing the financial effect of the modification over the remaining life of the contract. Under existing accounting guidance revisions to estimated margin rates resulting from modifications were reflected as cumulative effect adjustments to earnings in the current period.
ANTYA View: By making the standard prescriptive, accounting standard setters have taken away the leeway embedded within a principle-based approach. The new rules allow less flexibility in accruing and booking earnings. The “cumulative effect adjustments to earnings in the current period” is especially important as it relates to GE because, in each of 2016, 2015 and 2014 GE booked $2.2B, $1.4B and $1.0B in earnings based on “revisions that affected a product or a service agreement’s total estimated profitability”. In this manner, the company’s reported industrial earnings were boosted approximately 17% in 2016, 11.1% in 2015 and 9% in 2014.
Aviation Commercial Engines – Consistent with industry peers, the financial presentation of our Aviation Commercial engines business will be significantly affected as they will be accounted for as of a point in time, which is a change from our current long-term contract accounting process. Our current process applies contract-specific estimated margin rates, which include the effect of estimated cost improvements, to costs incurred. This change is required because our commercial engine contracts do not transfer control to the customer during the manufacturing process. Each install and spare engine will be accounted for as a separate performance obligation, reflecting the actual price and manufacturing costs of such engines. We expect that the most significant effect of this change will be reflected when we have new engine launches, where the cost of earlier production units is higher than the cost of later production units because of cost improvements.
ANTYA View: This is a thought-provoking development because program accounting and learning curve usage is common in aerospace accounting where average cost concept is used to smoothen earnings because costs are higher in initial years and lower in later years. We see two developments which will make earnings lumpy and volatile.
The first is that the management loses the ability to control and manage margin disclosure on existing products, increasing earnings amplitude because each aircraft-engine becomes a distinct production item. The company’s disclosed costs under the new approach could be materially different for each aircraft-engine manufactured versus the average-cost or learning-curve based approach. Second, costs associated with developing innovative technologies are lumpy and will bring an additional burden of disclosures and required justifications with them, as well as, compress reported margins in early years of production runs.
All of this is devoid of any cash impact but materially effects EPS going forward, and hence GE’s concerted and deliberate attempt to focus on industrial free cash flows from operations and direct investors to that metric.
All Other Large Equipment – For the remainder of our equipment businesses, the new revenue standard requires emphasis on transfer of control rather than risks and rewards, which may accelerate timing of revenue recognition versus our current practices. For example, in our Renewable Energy business we wait for risk of loss to be assumed by the customer before recognizing revenue, which generally occurs later than when control is transferred.
ANTYA View: This is perhaps attributable to performance guarantees provided by the manufacturer when delivering wind turbines. Although GE will be able to recognise revenue earlier, its obligations do not go away and once again no cash impact but higher/lower EPS.
CURRENT RANGE OF FINANCIAL STATEMENT EFFECT
We[GE] will adopt the new standard as of January 1, 2018. When we report our 2018 results, the comparative results for 2017 and 2016 will be updated to reflect the application of the requirements of the new standard to these periods.
Based on our assessment and best estimates to date, we expect a non-cash charge to our January 1, 2016 retained earnings balance of approximately $4.3 billion. We estimate that the charge will comprise approximately $1.0 billion related to commercial aircraft engines and $3.3 billion related primarily to our services businesses (predominately in Power and Aviation). … Given the inherent difficulty in this ongoing estimation of the effect of the standard on any future periods, we do not plan to continue to assess the effect on 2018.
ANTYA View: For Q4-17 GE’s industrial segment reported book equity of $64.3B including its ownership of 62.5% of BHGE. Therefore, when GE reports Q1-18 results, ceteris paribus we would expect GE’s book equity to decline to approximately $60B. Assuming the current P/B x of 2.0 stays put, there is downside of at least $1/share or about 7% on current price. Also, recall that we highlighted earlier that GE booked a cumulative $4.6B in earnings on contracts in 2016,2015 and 2014. The company is now writing-off some of that and will re-book the same as income in later years under the new rules.
We are scratching our head trying to figure which earnings stream to pay for and at what multiple because this seems to be a parallel universe. More importantly, even GE readily admits that all of this is seemingly too complicated. What should investors do then? Investors can pray or pay a lower multiple on valuation metrics. We prefer the latter.
Importantly, application of the new guidance has no effect on the cash we expect to receive nor the economics of these contracts. Rather, it will simply more closely align revenue with cash, which we believe will be helpful to our investors.
ANTYA View: Of course, investors want cash because that is what matters at the end. However, it is unlikely that investors can be led astray into thinking that management can deliver free cash flow. Accounting changes do not create or produce cash flows. Accounting changes as envisioned by FASB and being implemented by the industry force management to come along for a ride that investors can partake in as well because a prescriptive approach keeps disclosures kosher.
We neither doubt GE’s sincerity nor its intent to deliver on its promises made to investors. We just have misgivings about the stability, the consistency and the growth in free cash flow that will be forthcoming at GE.
On metrics that matter to ANTYA such as free cash flow yield, P/B, EV/ EBITDA, dividend yield and accounting transparency, GE does not deliver the goods yet. Investors too should think twice about sticking around. We know of at least 15 Dow companies that provide better value than GE going forward. Some might argue that all 29 Dow components are better bets.
