Brooke Sutherland
TT

Factories Are Gearing Up for a Post-Covid Boom

This week marked one year since the World Health Organization declared the coronavirus outbreak a global pandemic, and what a year it’s been. But if you had been lucky enough to live under a rock and avoid the whole thing, the starting and ending data points for the manufacturing sector might leave you scratching your head as to what all the fuss was about. US manufacturing activity expanded in February at the fastest pace in three years, according to Institute for Supply Management data. Copper prices, a key indicator of industrial demand, are near a decade high. The S&P 500 Industrial Index is trading almost 20% higher than where it ended 2019. CEOS at companies including 3M Co., Stanley Black & Decker Inc. and Caterpillar Inc. are spending like there’s no pandemic. By almost every measure, the industrial recovery is well underway and accelerating. It's remarkable when you stop and think about it.

Even in the beaten-up aerospace sector, a wave of pent-up demand for summer travel is giving reason for hope. This week, an American Airlines Group Inc. bond sale backed by the company’s frequent-flyer program drew $45 billion of orders. That’s partly a reflection of the attractive yields on what eventually amounted to a $10 billion offering, but given American’s junk credit rating, investors also had to be feeling optimistic that loyalty programs will become useful again, particularly for the corporate crowd that’s among the biggest users. United Airlines Holdings Inc. locked in a deal for 25 more of Boeing Co.’s 737 Max jets and accelerated some deliveries to 2022 to take advantage of “the growth opportunities that we know will exist in the Covid-19 recovery period.” Southwest Airlines Co. may not be far behind: The carrier is reportedly close to a deal for 150 to 200 of the smallest version of the Max after considering a rival plane from Airbus SE. Even before accounting for a potential Southwest deal, Boeing’s backlog rose for the first time in more than a year in February as jet sales outpaced cancellations.

Of course, nothing is perfect. In manufacturing, the speed and strength of the snapback in demand from the desolate levels of last spring is wreaking havoc on supply chains and sparking concerns about rising costs for raw materials, freight and labor costs. But CEOs at large manufacturing companies have been surprisingly sanguine when queried about inflation and have expressed confidence they can offset increasing costs with price hikes of their own. These are good problems to have in the scheme of things. It’s easy to forget after the events of last year, but before the pandemic, the industrial sector was looking at a pretty pokey 2020.

Humor me for a trip down memory lane to last January: the US-China phase-one trade agreement reached in late 2019 had sparked a rally for the manufacturers that had borne the brunt of tit-for-tat tariffs, but investors were getting wise to the fact that the agreement wasn’t all it was cracked up to be. Case in point, the levies on industrial goods are largely still in place even today. Outside of the trade war, there just weren’t many reasons to hope for a growth spurt. ISM data showed US manufacturing activity closed out 2019 with a fifth straight month of contraction. Heading into the year, CEOs overall listed the risk of a recession as their top concern for 2020, according to a global Conference Board survey.

“Manufacturing is going to be sluggish but stabilized,” Federal Reserve Bank of Dallas President Robert Kaplan said last January. Speaking later that same month, Caterpillar CEO Jim Umpleby warned of “continued global economic uncertainty.” Again, this is pre-pandemic. “I just think we’re tapped out” on industrial stock gains, Kathryn Rooney Vera, chief investment strategist at Bulltick LLC, said in an interview on Bloomberg TV with me and David Westin, also in January.

And now here we are talking about increased capital spending, demand in some sectors that’s so strong suppliers can barely keep up and the prospect of a boom in heavy-duty machinery purchases in markets such as agriculture, mining and housing construction after years of underinvestment. Asked this January why Caterpillar wasn't yet willing to provide formal earnings guidance, CEO Umpleby said, “It isn't so much concern about downside. It is uncertainty as to how much better things will get this year.” Many industrial stocks are sporting elevated valuations that already reflect this rosier outlook. But in a notable difference to the start of 2020, there's no longer the same contrast between markets’ enthusiasm and CEOs’ realism. These days, everyone is optimistic.

And Then There's GE

I actually spent most of this week thinking not of 2019 or pre-Covid 2020, but of 2017 and 2018. That’s how far back you have to go to find a General Electric Co. presentation that bombed as badly as this week’s outlook call. Shares of the company collapsed about 12% over two days before rebounding modestly on Friday. That compares with a similar 13%, two-day slide following the fateful November 2017 investor day when GE cut its dividend in half and then-CEO John Flannery unveiled a much-hyped but ultimately unimpressive turnaround plan that essentially amounted to a slow grind of cost cuts and asset sales. In May 2018, GE shares fell 7.3% after Flannery told investors that there was no “quick fix” for the company’s woes. GE is different today; in 2017 and 2018, it wasn’t uncommon to have conversations where investors pondered if the company would even survive. Current CEO Larry Culp deserves credit for bringing GE back from the brink and stabilizing it. But the experience of those past outlooks is still instructive: all these years later, there’s still a huge misconception about what a GE turnaround actually looks like.

The major headline out of this week’s investor day was that the company is merging its GECAS jet-lessor unit with rival AerCap Holdings NV. GE will receive $24 billion in cash (plus $1 billion of notes or additional cash) and a 46% stake in the combined entity that it can sell off in full after 15 months, if it chooses. GECAS was the best part of GE Capital and the only real source of profits in that business, so the divestiture will also essentially bring an end to this one-time financial juggernaut. GE’s remaining financial assets — mostly a legacy long-term care insurance business and a smaller equipment-financing arm that supports the power and renewable-energy units — will move under the industrial corporate umbrella and the company will report results on a consolidated basis. Investors have been clamoring for a simpler GE for years and this transaction certainly gives them that, but they appear not to have bargained for what untangling the company actually entails and to have been unpleasantly reminded of the complex relationship between the finance arm and the core industrial operations.

As much as investors disliked GE Capital, it had its benefits. GE could sell spare jet engines to the GECAS lessor arm or other off-balance sheet subsidiaries at a high margin, a practice that critics said inflated results for the aviation segment in recent years. The company also relied on factoring programs — or the sale of accounts receivable to the financing arm in exchange for cash to help with short-term funding needs. In conjunction with the consolidation of GE Capital, GE plans to significantly — although not entirely — wind down this practice. This will result in a $4 billion to $5 billion one-time hit to cash flow this year, Chief Financial Officer Carolina Dybeck Happe said. GE is excluding this from its official 2021 free-cash-flow forecast, which remains at $2.5 billion to $4.5 billion. While the GE industrial parent guaranteed certain GE Capital debt, the two entities were mostly treated separately in company presentations and by the ratings firms. Not any more: GE expects to pay down $30 billion of debt with proceeds from the GECAS deal and existing cash, but because it’s now consolidating GE Capital on its balance sheet its leverage ratio will stay the same at about 6 times expected earnings before interest, taxes, depreciation and amortization. This doesn’t compare favorably to industrial peers and S&P Global Ratings said it expects to lower GE’s credit rating. JPMorgan Chase & Co. analyst Steve Tusa said the rejiggering is forcing investors to realize that the GE Capital assets are "generally illiquid, cash cost centers essential to generating whatever earnings and cash the company delivers."

On the whole, I think this transaction was still the right move for GE. The company’s clear preference for shrinking its finance assets means it wasn’t the best owner for the jet-leasing business, particularly with demand for leased jets expected to rise post-pandemic as heavily indebted airlines favor that option over buying their own planes. The equity stake will allow GE to benefit from this recovery without having to put up the necessary capital. The real test of the simplification message will be the disclosures GE provides for the finance assets once they’re consolidated in its corporate reporting line; historically this segment has been just as much of a black box as GE Capital, as Gordon Haskett analyst John Inch notes. Culp said this week that GE intends to continue providing the same amount of transparency on the insurance assets as it has been. GE investors may not like being reminded of the clunkier entanglements of GE Capital today, but the company was never going to be able to stage a meaningful recovery if there was a constant debate on Wall Street about its "real” leverage levels and earnings power. For better or worse, this is the closest GE has come to a true reset.

Bloomberg