Steve Tusa, Wall Street’s GE Bear

JP Morgan’s Steve Tusa is Institutional Investor magazine’s #1 ranked analyst covering the Electrical Equipment & Multi-Industry sector. He has covered the sector since 1998, with lead coverage since 2005. In 2017, he gained notoriety for being Wall Street’s lone outspoken bear on GE, when the stock was trading in the $30s. After the stock dropped by more than 60%, some Wall Street commentators labeled the call “one of the greatest stock calls of all time.” Note: This interview occurred on September 5th, 2018.

Graham & Doddsville (G&D): In May 2016, you went from having a No Rating on General Electric to an Underweight rating. Can you talk about your research process and what prompted the call?

Steve Tusa (ST): Absolutely. I got the senior position [at JP Morgan] in 2005, and we have been covering GE since then. We went on restriction because JP Morgan Investment Bank helped them divest most of GE Capital, so that’s why we didn’t have a rating in 2016. Actually, right before they announced the GE Capital divestiture, we put out a presentation that was one of our “Where we could be wrong” reports. The report basically said, “Look, we’re negative today. We understand the stock is cheap. We’re trying to get positive, but here are the reasons why we can’t.”

A few weeks after we put out that report, GE announces the GE Capital transaction. The stock goes up a lot because the negative thesis on GE in the past was that they have a big finance arm that nobody understands, which is a big risk, and therefore the stock deserves a significant discount on earnings. That had been the drag on GE forever. When they announced they were getting out of GE Capital, the market reaction was, “Okay, the shackles are off.” The bulls were saying that the divestiture was going to unmask all the great things about GE Industrial.

We went on restriction because of the deal. You’re not allowed to do much when you’re on restriction because of the wall between banking and research, but you can watch the stock and you continue to maintain a model. You certainly don’t send that model out, and you certainly don’t talk to clients, especially about things other than pure facts. But it was instructive being on the sidelines and just watching for the better part of a year.

After GE unloaded GE Capital, the company started talking a lot about their digital platform — that’s when IOT started to emerge on the scene, and GE was making a big pitch around IOT — which many investors were buying into. Since we were on the sidelines, we got to really step back and absorb what was going on with related expectations. Yes, they were losing a lot of earnings and cash flow with GE Capital, but they said they were going to backfill some of those earnings and cash flow with buybacks and capital deployment, meaning less dilution, while their positioning in IoT would drive a higher multiple.

What we saw was a growing discrepancy between a) earnings expectations and what the end markets were suggesting, and b) earnings expectations and cash generation. Back then the big expectation was $2 in earnings per share (EPS), and everybody believed GE could get to $2 in EPS through cost cuts, capital deployment, and end market growth. The stock was in the high $20s at the time, and the bull case applied a 20x P/E multiple to $2 in EPS to get to $40. What we noticed was the industrial cash flow was not growing as fast as the earnings suggested.

At that time, our tagline was, “Estimates are too high and cash is too low.” We basically thought that their EPS would come in closer to $1.80 than $2, of which cash flow would be closer to $1.50-$1.60. That may not sound like a big miss, but in the context of my coverage universe, where a lot of companies were beating numbers and many had above 100% conversion of cash flow on earnings, we thought that either the stock was dead money on a modest earning miss, or it could drop by 10–20% on a more significant earnings miss.

Our process for GE was not typical for most of the Street. Our initiation report was 200 pages because a) a lot had happened between the time we went on restriction and the time we came out Underweight, and b) when making a call like this, it’s important to be extremely open and honest with clients and the company. Lay it all out there. Show them your work so they can agree or disagree.

That 200-page report was just the start. You start by pulling a little bit of string, but soon you try to pull as much as you can. The more you pull that string, the more your knowledge base enables you to understand data points and news flow and put them in the proper context.

For example, we had a couple meetings with financial services people regarding GE Capital and its downturn, and I could tell right away that its scope was beyond me. But I had enough of a background to know exactly where to dig and go deep, and soon enough I became like a financial services analyst. With GE and the size of its legacy financial services business, mastery of the balance sheet becomes crucial; you have to understand the complexity of how it all fits together. As you go through the process — we’ve written 1500 pages on GE in the last two years — it allows you to recognize the next step of the process because you’ve done the work. But again, the point is that we didn’t know everything in 2016. You begin to see the whole picture as you work through it, and this time, probably the biggest swing factor has been the Power business. Here, because of the work we’ve done, executives from GE’s competitors like Mitsubishi Heavy and Siemens will read our work, and they actually start emailing and calling us to talk about the industry.

The research builds on itself in so many different ways. The key to it all is learning; if you’re still learning something, you keep going. You don’t know when it’s going to pay off, but the depth always pays off at some point. For example, a bunch of Power data points have come out in just the last three or four months, and we’ve written three reports in the last three months about how Power is going to get worse before it gets better. And just today a competitor came out essentially reiterating our research and cut his price target by 20%. The key is to be out in front of those guys.

G&D: Was the rest of the Street bullish when you came out with that first Underweight rating in May 2016?

ST: Everybody was, yeah.

G&D: What kind of pushback did you get?

ST: The pushback was interesting because there were a lot of generalists in the stock, and generalists don’t tend to dive as deep as the analysts do. Our initial call was on cash flow. When GE sold GE Capital, they sent all the cash from those sales up to the parent as a dividend, and their cash flow guidance included those dividends. If you were just looking at Bloomberg you would’ve seen about $25 billion dollars of free cash flow, but that included the massive dividends from GE Capital. Inherently, that was a one-time item. So, if you were a generalist and you were looking at GE on Bloomberg, you would’ve checked the box on free cash flow and said, “Yeah. Okay. Fine.” I remember explaining to people, “No! Here’s how you walk to my free cash flow numbers.” I wasn’t even talking about a dramatically differentiated view, I was just explaining the numbers and reporting structure. I mean, even as recently as last year, there were competitor reports showing historical free cash flow conversion that included a GE Capital dividend.

The other big pushback was that I was too negative on the oil and gas market. Looking back, that was probably the easiest layup in this whole analysis. The rest of the stuff was a little more nuanced.

G&D: When a company is cutting costs, how can you tell if they have cut too far?

ST: You have to know the business well enough to be in touch with the channel. Feedback from the channel will either reveal a dip in service quality or a lack of buzz around new products. Often, you’ll see it in growth rates versus peers, sales per employee versus industry-specific peers, and SG&A as a percentage of sales. GE was pitching SG&A reductions, but their SG&A was around 12% while peers were around 20%, and a big part of SG&A was pension expenses which is not really something you can cut. Again, if you know the channels you’re going to hear feedback regarding the quality of the service, and you can judge from that whether they need to spend more money.

G&D: What were Jeff Immelt’s major missteps before he stepped down?

ST: I think everybody would agree that when you come in as a new CEO and replace a legend like Jack Welch, it’s very hard to walk the fine line of not “resetting.” I don’t think there was a real reset. He must have known that Welch’s performance was unsustainable. A wise man once said that being CEO of GE is like being a head of state. It’s a very hard, complex job with many different constituencies.

I think one of the big issues was the culture. Most people who worked there will tell you that bad news was not tolerated, and if bad news were to arise, they would try to do something to make it look better. For example, GE’s Alstom purchase, as part of the Power business, was not a good strategic decision — $10.5 billion of cash they really could have used is currently generating negative cash flow. Same thing, quite frankly, with their Baker Hughes acquisition. Baker Hughes cost them $7 billion of cash to try to patch up the oil and gas segment as that market collapsed on them. I think those moves are probably a result of the cultural mindset. I wasn’t covering the company when Jack Welch was there, but the culture probably needed to change over time. Their new management has acknowledged that. They’re working to change it, but it’s a hard problem to address with a 300,000 employee company, and it’s especially hard to address over a nine-month period when you are constantly putting out fires like internally-sourced CEO John Flannery was.

I’ve been vocal in our research about GE’s lack of external hires. It’s hard to change a culture with people that have been there for decades. I’m skeptical that they can change quickly without some fresh blood. Now, 30% of the board is new, so they’ve got fresh blood there. And I really admire Larry Culp — I think he’s the best CEO our sector has ever had — but I think it takes more than a couple of board members to change the culture of a large organization. That’s going to be a long, long process.

G&D: Didn’t they reduce the size of the board too?

ST: Yes, they reduced the size of the board as well. It’s hard to make quick decisions with a board of 18 people. The old board had some very legendary people on it, but I think the new board is much more lean and agile.

G&D: Here’s a quote from one of your reports: “Put simply, poorly timed investments to catch up in emerging markets, optimistic growth assumptions for resource-rich countries, and a corporate imperative for market share have left the company with structural overcapacity, mostly in Power, oil and gas, and transportation.” Can you expand on that?

ST: At GE’s peak in 2000 — when Jeff took over — GE was trading at around 40x earnings. That was clearly unsustainable. How do you take a $150 billion company and grow it into something that can actually sustain that multiple? They started moving further out on the risk curve by placing bigger bets in very visible ways. Typically, those bigger bids are going to be more competitive. GE went into Saudi Arabia to try to help them build their Power infrastructure, but Mitsubishi and Siemens were there in the same conference room, bidding for the same projects. GE winds up announcing a $5 billion deal to build the facility, and they hire 700 locals to get the deal done.

Now what happens to that business? If there’s no follow-on order in the next two years, or if there are a bunch of follow-on orders followed by a collapse in oil, you know that they have set up shop for 50 years but ultimately probably only have enough to fill up half of it. You have to go through each press release and understand what the makeup of each deal is, and then you have to watch to make sure there are follow-on orders, and you have to track the returns over time. The Middle East was 35% of demand for gas turbines for several years, while GE is sitting there with this plan to build and service gas turbines that suddenly aren’t being ordered.

Again, you have to track everything. Everybody is probably bullish when that press release comes out. But you put that in the back of your mind and say, “Saudi Arabia, is that really sustainable? Is it dependent on oil prices?” And ultimately, when oil prices go down and people are worried about selling Schlumberger, you think in the back of your mind, “Wait a second, didn’t GE have to build that plant and book that order in Saudi Arabia? How much demand was that for them?” You start connecting the dots and realize, “Wow! That’s probably not going to end up looking like a good investment.” And sure enough, there was an announcement in the press two months ago that Saudi Arabia is now bidding out the service work on GE’s gas turbines in the Kingdom, which is the more profitable part.

The point is that GE went everywhere to grow revenue just to justify the multiple. When you do that, you move further and further out on the risk curve.

G&D: What are your big takeaways from covering GE for the past two years?

ST: Read everything you can. Know the balance sheet and the cash flow statement inside and out. Most companies are not this complex and don’t have this many moving parts. GE’s 10-K is 270 pages, whereas most 10-Ks are closer to 100 pages. Talk to everybody in the channel. Learn about the business and do your own work.

Management teams are going to be bullish about their businesses. They’re leaders, and they’re optimistic people by nature. But you’re in a seat to take a differentiated view, and if the numbers show you something different, go with it. Don’t worry about what other people are saying or what’s driving the stock’s initial return. If your thesis is right, the stock is going to go where it’s supposed to go.

When you have a better base of knowledge than anyone else, go all in and be as vocal as possible. I don’t want to overstate the drama, but that’s it. And by the way, GE’s stock didn’t go down until about one year into the call. But by the time something finally started happening in the second quarter of last year, we had already developed a honed-in view of the power market and were able to see through the noise. When they made cautious comments on the second quarter 2017 call, we knew right away what the issue was. I remember pinging my associate Rajat, saying, “Wow, this is it. It’s happening.” Meanwhile, most of the people recommending the stock probably just asked the company about it and were told something like, “Well, we’re still in good shape, and this is temporary.” But we knew exactly what was happening. Again, we had read through utility filings to figure out what they were doing with their Power upgrades and how the accounting works. Fundamental research — in-depth fundamental research — absolutely works.

G&D: Do you think GE was ripe for a differentiated view because of how complex the company was?

ST: Yes, 100%. They’re a very good marketing company — ecomagination is brilliant, right? Those leading digital industrial TV commercials are great. Outside of marketing, you have this financial beast with three different balance sheets. When you combine complexity and marketing — I don’t think we’ll ever see this confluence again. Look at Apple — they’re not that complex, right? You just need to predict how many iPhones they will sell. Stock going down in a company the scale of GE — this has been a confluence that I don’t think I’ll see again in my lifetime.

G&D: How do you prepare for a media appearance on CNBC where you only have three minutes to deliver your pitch? What is your mindset?

ST: Well, I’m supposed to wear a suit and tie, but I always change into a golf shirt and vest. Just kidding. No, I just make sure I have the talking points in my head. When you talk about something that you know, you don’t need to prepare. This job is a lifestyle. It doesn’t consume me all the time, because I love my family and there are other things I like to do, but it does fill the gaps. I was a radio host in college and like to talk, so that also helps.

I interviewed at another bank a long time ago, and the product manager there had a great saying: “Make ’em think, make ’em laugh, make ’em money.” I think that’s the key to this job. There are a lot of people who are fun who you wouldn’t mind grabbing a beer with. Then there are some people who do really good work who can make you think. But there are very few who can really make people money.

But if you can do all three of those? That’s what I try to do. I didn’t go to an Ivy League school which I think gave me a little bit of a chip on my shoulder. That kind of drives you to work harder than the other guy. And I do believe this GE call has been about hard work. It’s not about me being brilliant — you should see how I handle my personal financial statements. It’s not pretty.

G&D: We usually close by asking for general advice for MBAs heading into the investment management industry.

ST: Wow. Pray that fees stabilize. Just kidding, don’t write that. I think intellectual curiosity is key, because that’s ultimately what will drive you. Be intellectually curious, but also understand that this is a very long game. Nothing comes in the first several years. I think it takes six years, almost a full cycle, for somebody to really learn the business. I got the senior job at JP Morgan in 2005 and have been covering this group since 1998. It would have been very hard to make a call like this in 2008. So, don’t sacrifice the long term for the short term, and build a strong base of knowledge so that when the time does come, you’re dangerous. I can look back and think about all the different paths I could have taken, but this is the only path that would have led me to this call. It comes down to your body of knowledge, the team you build, the support from your managers, all that stuff. I really do believe though, that if you work hard for a long period of time in this business, it’s worthwhile.

[Editor’s Note: The initial interview occurred on September 5th, 2018, before Larry Culp was named CEO. The following comments were provided to G&D on October 15th.]

G&D: What are your thoughts on the recent development of Larry Culp replacing John Flannery as GE CEO?

ST: As I highlighted back in September, Larry Culp is one of the best CEOs ever in our sector. However, this is a big, complex ship to turn, and the job in front of him is nothing like the one he had at Danaher. That was all about how effective he was at deploying an abundance of available cash from operations and the balance sheet, as well as building on good businesses and a great operating culture. This is the exact opposite — essentially a work out situation with 50% of the businesses highly challenged and generating negative cash flow, and a highly levered balance sheet that needs to be unwound from years of cultural financial engineering.

Once again, the Street is getting bullish simply because there’s a new CEO. We haven’t even seen how bad the numbers are, and we have to note that GE further cut already-low guidance when announcing the new CEO. Weak free cash flow and high leverage is a bad combination that we think will ultimately resolve itself in a dilutive way for shareholders. The new CEO is a start to the healing process, but unwinding this financially engineered ecosystem is going to require more than just cost cuts. It’s going to take time, and probably much more capital. In the end, we think things get materially worse before getting better.

G&D: Thank you.