General Electric Stock Downgraded: What You Need to Know

Mark your calendars and update your scorecards, investors. On May 12, the number of analysts rating General Electric (NYSE: GE) stock a sell (or its equivalent) doubled: 9-6-2.

That's nine analysts rating GE a buy or outperform, six a hold or neutral, and as of today, two analysts saying GE stock is a sell. Here are three things you need to know about that.

General Electric stock suffered a bear attack this morning. Image source: Getty Images.

1. Deutsche Bank joins the bears

You can thank Deutsch Bank for creating the new negativity around General Electric. This morning, Deutsche became the second professional analyst to recommend selling GE stock, issuing a rare sell rating and cutting its price target to $24. But why?, which covered the ratings cut this morning, focuses on one key reason Deutsche has lost faith in GE: Cash. According to the analyst, there is a wide (and widening) gap between the accounting profits that General Electric reports under generally accepted accounting principles (GAAP), and the actual cash profit that General Electric is generating from its business (free cash flow).

How big is this gap with GAAP? Actually it's enormous, and growing. According to data from S&P Global Market Intelligence, General Electric reported "earning" GAAP net income of $8.8 billion last year, but its free cash flow was negative $7.4 billion -- a difference of $16.2 billion. By Q1 2017, rising earnings ($9.3 billion), contradicted by increasing levels of cash burn ($7.7 billion), had expanded the gap to $17 billion.

2. Bad and getting worse

Digging deeper into the downgrade, explains that Deutsche Bank's concern with "weak earnings quality" at GE, and the "wide gap between non-cash and cash earnings," derives largely from Deutsche's "exclusion of non-operating pension accounting along with a high level of underfunded pension obligations." In this regard, it's worth pointing out that S&P Global data show that GE's "projected benefit obligation" has swelled 31% in size over the past three years, and now exceeds $94 billion in value -- while assets available to pay these benefits amount to less than $63 billion.

3. Here comes the taxman

As a corollary concern, not directly related to the divergence between GAAP accounting profits and free cash flow, Deutsche also notes that GE has been paying "ultra low tax rates" in recent years. And here again, S&P Global data bears out the point. In fact, GE's recorded "income tax expense" has been negative for more than a year now.

Deutsche worries that this could "pose a future earnings headwind" if and when GE starts paying taxes more in line with what the tax code says it should be paying. That would cut into GAAP reported profits -- and could make free cash flow even worse than it already is.

Time to panic?

The obvious question: How worried should investors be by these concerns that Deutsche Bank has raised? Because with GE stock diving 3% in the wake of Deutsche's report, it's clear that some investors are worried.

Well, not to go whistling past any graveyards here, but I don't think there's any huge need to panic. Here's why not:

Most of the concerns Deutsche highlighted derive from a review of GE's cash flow statement. GE's balance sheet, however, shows that while cash levels declined by $2.6 billion over the last three months, long-term debt declined even more -- $5.4 billion (and "other non-current liabilities" declined by $2 billion). Thus, between Q4 2016 and Q1 2017, it appears that GE's cash position actually improved by $4.8 billion -- the opposite of what you'd expect to see happen if GE was really burning cash at the rate of $17 billion.

In short, I think there may be more to this story than what's reflected on GE's cash flow statement alone -- which is often the most volatile of the three main financial statements that companies file with the SEC. I'd also point out that if you take a longer view of things, and smooth out the cash flow statement's volatility, GE has historically been a pretty good producer of cash. Over the past five years, for example -- including the year 2016, which spawned Deutsche's concerns -- GE has on average generated about $14.1 billion in annual positive free cash flow. That actually compares pretty well to GE's $8.9 billion in average annual earnings over the period.

While 2016 was clearly a bad year for cash production at GE, the longer term trend of $14.1 billion average annual cash profit tells me that GE is still pretty healthy, financially. At a valuation of 17.8 times that average annual free cash flow, I wouldn't call the stock cheap, exactly. But neither do I see it as so expensive an investor should feel compelled to run right out and sell it immediately.

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Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of General Electric. The Motley Fool has a disclosure policy.