General Electric Company (GE 2.31%) reduced its full-year 2016 revenue outlook. Does that mean investors should sell the stock? The reduction, which the company announced while providing third-quarter results on Oct 21, has since been overshadowed by the announcement of an agreement to merge its oil & gas operations with Baker Hughes Incorporated (BHI +0.00%). However,the two actions should be thought about jointly when considering what you should do with the stock. Here's what you need to know:
General Electric Company's outlook
Going back to the second-quarter results, CEO Jeff Immelt maintained the existing forecast for organic growth of 2% to 4% in 2016 but guided investors toward "the bottom end of the range" -- a downgrade in all but name.
Fast forward to the third-quarter and Immelt now expects 0% to 2%. In the context of the original forecast, you could take a glass-half-full approach and see this as a reduction of possibly low 2% to high 1%, or a glass-half-empty approach and see it as a reduction from 4% to 0%.
Weak oil and gas capital spending is the reason for the outlook cut. Image source: General Electric company website.
Why the cut?
No matter. It's a reduction all the same, but the really important thing is the reason for the change. Answering a question from Credit Suisse analyst Julian Mitchell on the recent earnings call, Immelt claimed it was "primarily oil & gas" with "maybe just a touch in some of the other ones."
CFO Jeff Bornstein continued, "So moving from 2% to 4%, to 0% to 2% is mostly about where we think the revenue number is going to end up with oil & gas," then pointed out that the oil & gas operating profit outlook (ex-foreign exchange) hadn't been changed -- meaning an expected decline of some 30%.
Indeed, the forecast range for operating EPS was merely narrowed to $1.48 to $1.52 from $1.45 to $1.55. The mid-point is the same even given that foreign exchange is expected to reduce EPS by $0.04 to $0.06 compared to a previous estimate of just $0.02.
Moreover, Immelt maintained the goal, originaly outlined in April of last-year, for EPS of $2 by 2018. So does the revenue guidance reduction really matter?
What it means
In the context of General Electric's future earnings, I happen to think it does matter. It's highly relevant in the sense that it highlights the increasing importance of energy prices to the outlook of the stock. I have three points:
- It really is all about oil & gas
- Despite the cost synergies -- largely a matter of management execution -- in the Baker Hughes deal, the new company's prospects will still be guided by energy prices, and the deal only increases General Electric's exposure to the sector
- Management can only cost-cut in existing oil & gas segment for so long, and the end-market outlook has progressively worsened as the year has progressed
To the first point, it's worth noting that, excluding oil & gas, year-to-date organic industrial revenue is actually up 4%, with management expecting 6% in the fourth quarter and 4% for the full-year. However, because oil & gas segmental revenue is expected to decline by 20% to 15% for the full year, overall organic revenue is expected in the 0% to 2% range discussed earlier.
General Electric company plans to integrate the industrial internet with Baker Hughes' solutions. Image source: General Electric Company.
Clearly the non-oil & gas parts of General Electric are working fine -- transportation was also weak with orders and revenue down 21% and 22% respectively, but that's also a consequence of weak energy and commodities pricing -- so the big variable in earnings looks likely to remain the oil & gas segment.
Baker Hughes
Of course, the Baker Hughes deal will only exacerbate the importance of energy. Management expects the deal to close in mid-2017 and to contribute $0.04 in EPS to General Electric in 2018, with synergies of $1.6 billion expected by 2020. Immelt describes them as "very straightforward and mainly on the cost side."
In other words, as with the Alstom energy assets deal, it's more about cost synergies, creating add-on value by adding Predix's Industrial Internet of Things solutions to Baker Hughes' solutions, and creating an integrated supplier with cross-selling opportunities than it is about growth synergies per se.
All of which raises a curious scenario wherein General Electric is cost-cutting in its oil & gas segment in order to preserve earnings in the near future, while investing in the Baker Hughes deal at the same time -- despite the fact that even if the Baker Hughes deal is looked at solely in terms of cost synergies, top-line prospects for the company will still depend on the oil & gas market.
General Electric Company's power turbine sales and deliveries remain on track. Image source: General Electric Company website.
Regarding the General Electric oil & gas segment, in December management promised $400 million in cost cuts in oil & gas for 2017, and subsequently raised that to a target of closer to $800 million to compensate for the fact that "oil & gas is, we expect, going to earn less than what we originally thought when we gave you the $2 framework 18 months ago."
Looking ahead
All told, the guidance reduction is significant, because it highlights the increasing importance of oil & gas as the arbiter of the company's earnings prospects. If you are comfortable with the idea that energy capital spending will bottom in the next 12 months then the stock is very attractive; if not, it might be one to avoid.
