Can GE stage a comeback by reviving its fabled collection of industrial businesses that make everything from ultrasound scanners to B-52 engines to turbines for nuclear plants?
That’s the pledge from its newly-installed, superstar CEO Larry Culp, who has praised GE’s “strong fundamentals on which to build,” and promised to “transform the way that we actually work, and run these businesses day in and day out.”
Today, the big news about GE isn’t the fate of those bedrock businesses, but the scorched-earth report from Harry Markopolos. The accounting sleuth who exposed scamster Bernie Madoff charges that huge, hidden losses in its long-term care (LTC) insurance business will soon drive the troubled conglomerate into bankruptcy.
But a careful assessment of GE’s industrial businesses reveals that right now, they’re performing so poorly that even if the insurance side doesn’t pose a major threat, as GE claims, the new management faces a tough task in restoring the conglomerate to profitability. An excellent financial measure we’ll get to later reveals that GE is generating tiny dollops of cash on a giant base of assets, the opposite of what a successful manufacturer needs to achieve.
The Markpolos report made investors nervous, and has triggered an 11% drop in GE’s stock price. But so far, the markets aren’t buying the full-blown disaster scenario. Wall Street is mostly backing Culp and audit committee head Leslie Seidman, formerly America’s chief accountant as head of the Financial Accounting Standards Board (FASB), who’ve countered that GE’s holds fully adequate reserves to cover future claims on its LTC portfolio. GE’s leadership also asserts that Markopolos lacks all credibility because, as he’s acknowledged, the “whistleblower” is benefiting financially from trashing GE. Markopolos has disclosed that he’s working with an un-named hedge fund that’s paying him a share of their profits from shorting GE stock.
The problem is, even if Culp can gradually exit LTC without the dire consequences, GE’s future will depend on the performance of four industrial mainstays: power, healthcare, aviation, and renewable energy. GE isn’t failing because a troubled insurance unit is dragging down a solid industrial arm—that arm looks feeble, too.
A decade of upheaval
In the last decade, GE has been in a state of constant upheaval that’s obscured the condition of its surviving businesses. Since 2009, it’s sold more than a dozen units including media (NBC Universal), appliances, transportation, and most of the GE Capital financing operations, while pursuing unsuccessful mergers with Alstom (rail transport) and Baker Hughes (oil and gas). What GE paid in dividends and spent on share repurchases bore no relation to its actual profits. That’s because it used much of the over-$200 billion in proceeds from asset sales to fund gigantic outlays for both. From 2009 to 2018, it spent roughly $130 billion on the dividends and buybacks combined, almost $80 billion more than its net profits over those ten years.
Going forward, GE will need to rely on cash flows from those four chosen survivors to reward shareholders. A reliable measure of how well they’re doing is COROA, or “Cash Operating Return on Assets,” a yardstick developed by accounting expert Jack Ciesielski. COROA measures how much cash a company generates each year from all of the assets invested in the business. It shows how profitably management is deploying the plants, IT, inventories, and working capital entrusted to them by shareholders.
The first building block is “operating cash flow.” It’s simply the reported cash from operating activities, as reported on the GAAP cash flow statement, plus cash paid for interest and taxes, which results in the cash produced from running the business. The denominator consists of all the dollars invested in assets; that’s assets as reported, plus “accumulated depreciation and amortization.” Why add those back? Because adding them back arrives at the total dollars spent on the assets being deployed to generate a return.
GE’s numbers chronicle a steep and ongoing decline. In 2013, it posted operating cash flow of $35 billion; it’s fallen in every one of the five succeeding year, hitting $10.5 billion in 2018, a drop of 70%. This resulted mainly from a slide in the cash it books from running its basic businesses. Its reported cash from operations (before adding back cash interest and taxes) dropped from $30 billion in 2016 to $4.2 billion last year. Because GE was exiting a lot more businesses than it was buying, its average assets also fell, but not nearly as far, a declining by around half. As a result, GE’s COROA, a crucial measure of its profitability, dropped from an already weak 4.8% to just 2.7%.
That compares poorly to leading industrial conglomerates: Thermo Fisher Scientific at 8.4%, Honeywell at 11.8%, and 3M at 15%.
But GE isn’t all industrial. Though it’s exited most of its former financing businesses, the GE Capital unit still holds the LTC franchise that Markopolos believes will sink the entire enterprise. What if GE Capital is a huge loser, so that the industrial side is really far more profitable than it might appear?
According to GE’s 10K for 2018, that’s not the case. The cash flow statement on page 101 reports that GE’s industrial businesses had cash from operations of a measly $2.258 billion. Add back interest and taxes, and its operating cash flow (from the power, aviation, healthcare and renewable energy units, and some smaller operations), totalled only $6.26 billion in cash, on average assets in those businesses of $288 billion. Hence, the industrial side’s COROA was an tiny 2.17%. So the problem wasn’t primarily GE Capital, home of the insurance franchise (though that could change going forward).
It’s possible that the $6.26 billion number is understating the industrial side’s ability to generate cash. Last year, it made $6.3 billion contribution to its pension plan, a addition that, GE says, covers its needs through 2021. Of course, funding a pension plan is a regular cost of doing business. Even so, it might be fair to add back two-thirds of that number, or $4.19 billion, the amount GE is effectively pre-paying. That would bring its operating cash flows to $10.45 billion ($6.26 plus $4.19 billion).
Even after that adjustment, GE’s COROA is a weak 3.6%. And in the first half of this year, GE reported negative cash from operations of $1.2 billion. Culp is promising big improvements. He declared on the Q2 conference call that he expects “industrial free cash flow to be in positive territory in 2020 and accelerate thereafter in 2021. Over time, as our operational improvements take hold, we continue to expect significantly better cash results.”
GE’s currently puny COROA won’t fly with a Larry Culp. As the chief of Danaher from 2001 to 2014, he forged a fantastic record squeezing more and more cash from every dollar invested in the plants and inventories that produced its precision dental instruments and water purification equipment. Danaher kept showing what an industrial conglomerate can accomplish, while GE proved a case study in squandering capital. In his final two years at CEO, Culp achieved average COROA of 11.3%, more than three times the GE industrial side’s record for 2018.
If Culp’s right that LTC doesn’t pose a threat, he’ll be striving for one of the great twofers in the annals of American business, building one industrial giant, and rescuing the foundering colossus that established the template.
More must-read stories from Fortune:
—The economy is in code yellow for a recession based on these 9 metrics
—The death of trading: Why more big banks think the business is a losing bet
—Recession watch: 3 ways to reframe your thinking about the next downturn
—What are negative interest rates and why is everybody so worried about them?
—Why WeWork won’t be in the S&P 500 after its IPO
Don’t miss the daily Term Sheet, Fortune’s newsletter on deals and dealmakers.