How Bad Bet on Power Put Spotlight on GE's Murky Accounting

(Bloomberg) -- General Electric Co. investors have long griped that the sprawling company’s financials can be a black box.

Now, securities regulators are poking around in one of the biggest and darkest corners of that box. GE’s power-equipment division, its single largest unit, has come under scrutiny -- alongside its ailing insurance business -- for how it accounts for revenue for servicing gas turbines and other heavy duty machines the company sells.

There are concerns about whether “GE made overly aggressive assumptions to drive earnings,” said Jeff Sprague, an analyst at Vertical Research Partners. “The burden of proof is on the company to prove otherwise.”

The U.S. Securities and Exchange Commission probe, disclosed last week, strikes at the heart of a company increasingly reliant on services and heavy industry. As GE shifts away from finance and consumer operations, the power unit is now responsible for almost 30 percent of GE’s $120 billion revenue.

Chief Financial Officer Jamie Miller said she’s not “overly concerned” about the issues under investigation, which also touch on an unexpectedly large $6.2 billion charge to reserves for an unrelated insurance portfolio. GE declined further comment.

GE made a huge bet in the power business in 2014. Former Chief Executive Officer Jeffrey Immelt announced a blockbuster agreement to buy Alstom SA’s energy unit, a $10 billion deal that still stands as the biggest in GE’s 125-year history. The company also launched a new turbine. Immelt promised that the product, along with a new jet engine, would generate $100 billion of sales.

Sluggish Market

Just as GE was placing its bet, the global market for gas power grew sluggish. Falling renewable-energy costs were luring customers away from fossil fuels.

Yet GE Power’s earnings remained stable thanks in part to revenue from high-margin contracts to maintain and repair turbines.

GE says it pioneered the long-term service contract business in the 1990s. Former CFO Jeffrey Bornstein described it to investors in 2016 as “a breakthrough” that helped GE build a services backlog in excess of $200 billion. It’s also a big factor in GE’s jet-engine unit.

But how GE records results from those contracts, which can stretch for decades, has been something of a mystery to Wall Street.

The company’s revenue assumptions are based on a multitude of variables -- such as the future expense of maintaining equipment and whether customers can pay the service costs. GE has acknowledged those uncertainties, revising profits upward in three years through 2016 by a total of $4.6 billion, according to company filings.

Another issue is that revenue is typically recorded when service is provided, even if GE hasn’t yet collected the cash from customers.

GE isn’t the only company using such practices, said Dan Mahoney, an analyst with CFRA Research, “But what’s concerning in GE’s case is a massive mismatch between revenues and cash.”

The difference between the booked sales and the total cash expected, known as contract assets, has ballooned. In 2017, it rose 15 percent to $28.9 billion, filings show, after nearly tripling from 2010 to 2016, according to Barclays Plc. The figures include both service and equipment contracts.

“The issue with these things is they’re based on assumptions of what happens in the future,” said Steve Tusa, an analyst with JPMorgan Chase & Co. Now, investors are increasingly wondering if GE will even receive all the cash it anticipates. “That is the million-dollar question, or the $28 billion question.”

Flannery Review

Investors have begun to grow wary of contract assets, particularly as GE ran into cash-flow problems over the past year. The depth of the issues didn’t emerge until after Immelt stepped down in the middle of 2017 and new CEO John Flannery conducted a review of the company.

In the power unit, he said that lower earnings would cut $3 billion off the company’s cash flow expectations for the year. Flannery pointed a finger at the unit’s former senior management, which was slow to acknowledge a market downturn. Steve Bolze, who as head of the division was a contender to succeed Immelt, resigned in June after being passed over for the top job, and others in the division followed.

“We did a poor job running that business,” Flannery told investors in November. A month later, the company announced 12,000 job cuts in GE Power, about 18 percent of the global workforce.

Flannery was also unsparing in his assessment of the Alstom deal, telling analysts the business “has clearly performed below our expectations.”

When GE disclosed the SEC investigation last week, the stock plummeted, contributing to a 7.6 percent decline this year. In 2017, the company was the worst performer in the Dow Jones Industrial Average with a 45 percent drop. In November, Flannery cut GE’s dividend for only the second time since the Great Depression.

“The story continues to unfold,” said Deane Dray, an analyst with RBC Capital Markets, “and the news has been all bad.”

--With assistance from Brian Eckhouse

To contact the reporters on this story: Richard Clough in New York at rclough9@bloomberg.net, Neil Weinberg in New York at nweinberg2@bloomberg.net.

To contact the editors responsible for this story: Brendan Case at bcase4@bloomberg.net, Larry Reibstein

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