General Electric (GE) does not appear to be able to get a break. Just after the industrial company released more than expected revenues in the second quarter of last month that included a significant increase in free cash flow guidance this year, allegations of accounting fraud triggered a serious sale of the stock on Thursday last week. I think GE's stock meltdown is extremely exaggerated (and temporary), and I'm discussing how investors should respond to the latest news.
General Electric – Second Quarter
General Electric reported better earnings than the second quarter of last month that caused GE's shares to revise the FCF outlook for the current fiscal year. Earlier, General Electric projected adjusted industrial free cash flow of $ (2.0) – $ 0.0 billion and now estimates 2019e adj. industrial FCF of $ (1.0) – $ 1.0 billion. The biggest upgrade in the FCF guide was a game changer for me and got my article "General Electric: This Is A Game Changer".
Accounting Fraud Allegations
Madoff warns Harry Markopolos last week that General Electric was involved in a $ 38 billion accounting fraud related to the insurance business. You can read the details of the claims on a dedicated website (here) that makes the core claim that the industrial company essentially needs to throw up its insurance reserves.
From the report:
Of the $ 29 billion in new LTC [Long Term Care, Insurance Business] reserves needed by GE, $ 18.5 billion requires cash immediately, while the remaining $ 10.5 billion is a non-cash GAAP fee as accounting rules require to be taken by 1QTR 2021. These impending losses will destroy GE's balance sheet, debt ratio and probable breach of debt covenants. Unfortunately, GE has almost no cash, so they had to ask for special patience from the Kansas Insurance Department to fund their $ 15 billion January increase over a 7-year time horizon, so the odds of funding $ 18.5 billion in new cash reserves are questionable. What is even more questionable is that GE became a cash flow positive in 2021, as management will believe you believe.
Investors did not take kindly to the allegations and dumped the stock. At the end of Thursday, General Electric's share was more than 11 percent in one of the worst sales in many years. Today, General Electric is much oversold based on the Relative Strength Index, which can be viewed as a contrarian "Buy" signal.
General Electric is already under investigation for accounting practices
General Electric disclosed a $ 6.2 billion fee related to the insurance business in the fourth quarter of 2017 and also said it would add $ 15 billion to the statutory capital of the insurance company. In addition, GE informed shareholders in January 2018 that the Securities & Exchange Commission was investigating its accounting practice. The SEC has therefore already examined General Electric's accounting practices for a year and a half at this time. As a result, GE, its accountants and auditors are very familiar with questions raised by the SEC regarding accounting practices.
General Electric's Response
On Thursday, General Electric posted a response to its website, calling accounting fraud allegations "meritless" and "unsubstantiated."
The claims of Mr. Markopolos are without merit. The company has never met, talked to, or contacted Mr. Markopolos, and we are extremely disappointed that a person with no direct knowledge of GE would choose to make such serious and substantiated allegations. GE operates at the highest level of integrity and is responsible for its financial reporting. We remain focused on running our business every day, following the strategic path we have set.
Furthermore, General Electric's CEO Larry Culp took the opportunity to show confidence in the industrial company and its value proposition by buying $ 2.0 million worth of GE shares under sale. Larry Culp bought 252,200 shares at a weighted average transaction price of $ 7.93. You can watch SEC filing here. Buying shares at times like this is the right signal to the shareholders of the company that the chief executive officer of the company is behind the accounting.
What am I doing now?
The most important thing is not to jump to any conclusions and sell your shares just because the GE report created a lot of waves. Selling into the weakness because fear takes over investors, in my opinion, almost always turns out to be a big mistake.
Investors must also keep in mind that the report was written by people who have a financial interest in GE's share price going down. According to the disclosure section of the GE report:
Prior to the initial distribution of this report on August 15, 2019, the Company entered into an agreement with a third party to review an advanced copy of the report in exchange for subsequent compensation. This compensation is based on a percentage of profits arising from third party entities' positions in securities, derivatives and other financial instruments and / or related to General Electric Company ("GE") (NYSE: GE). These positions held by the third-party entity are designed to generate profits should the price of GE securities fall.
If you have a long standing position in GE, like me, the best option in times of emotionally driven sales is often to do nothing. Let the storm pass and see how other analysts react to the news, which I expect would come out to defend GE. The market reaction to the report is, in my view, almost comical, and there is a good chance that GE's stock price will recover in the coming weeks.
Insurance professionals, accountants, and regulators, including the SEC, must find out if GE has an under-reservation problem. In that case, the company will have to tie up its reserves which will cost money. However, I doubt the final outcome will be as negative as investors currently fear because the SEC is already looking into GE's accounting practices related to its insurance reserves for nearly two years. In addition, investors must keep in mind that GE's CEO took the opportunity to extinguish a boat amount of cheap shares, and that the authors of the report have a financial interest in lowering GE's share price. Long GE.
Disclosure: I am / we are long GE. I wrote this article myself, and it expresses my own opinions. I do not receive compensation for it (other than Seeking Alpha). I have no business relationship with any company mentioned in this article.