After a difficult 2016 in which General Electric Company (GE 1.79%) failed to meet its original organic revenue growth target range, the company was under pressure to steady the ship in 2017. On the plus side, the recent first quarter was good from a headline perspective (revenue, earnings, margin etc); however industrial cash flow from operations (CFOA) came in $1 billion below expectations, with an outflow of $1.6 billion instead of the expected outflow of $600 million. Does that matter?
Industrial CFOA
Before going into the details of why industrial CFO missed internal expectations, I have two points for consideration. First, as you can see below, it's worth pointing out that GE's cash flow is always lumpy and weighted toward the second half. It's not unusual for GE to have weak cash flow in the first quarter.
Data source: General Electric Company presentations. Data in billions of U.S. dollars
Second, management maintained its guidance for industrial CFOA of $12 billion to $14 billion. Listening in on the earnings call, on the subject of industrial CFOA, CFO Jeff Bornstein further outlined that "we think CFOA is going to be sequentially much better in the second quarter than the first. And we would expect year-over-year CFOA to be better through the half, equal or better to the half."
Why industrial CFOA missed
That said, I would be remiss not to look into just why GE missed estimates with cash flow, and what that might suggest about underlying performance at the company.
Bornstein addressed the issue of the near $1 billion shortfall compared to expectations in his opening remarks on the earnings call. They are summarized in the table below, and consist of working capital items and what Bornstein calls "contract assets".
| Element | Industrial CFOA Shortfall |
|---|---|
| Receivables | $400 |
| Inventory | $100 |
| Progress collections | $300 |
| Contract assets | $300 |
Data source: General Electric Company presentations. Millions of U.S. dollars
Let's look at these items line-by-line, starting with receivables. Essentially, this is cash collected on outstanding invoices. Bornstein claimed that $200 million of the $400 million shortfall was in the aviation industry "on five customer accounts, which will clear in the second quarter with no issue." This leaves a further $200 million in power, and here there is a concern. Bornstein outlined the monies outstanding is on "delinquent accounts in tough regions," such as the Middle East. He expects to collect throughout the year, but he did not put a figure on this, either for the full-year or the second-quarter.
Inventory and progress collections
The $100 million in inventory shortfall was due to "softness" in the U.S. healthcare market. In other words, sales were lower than expected, so inventory reduction was less than expected. Bornstein claimed it was mostly "timing around sales and orders" and said he wasn't concerned about it. From a CFOA perspective, he's probably right -- inventory can be cleared -- but if this is symptomatic of ongoing weakness in healthcare sales it might be a concern.
According to GE, "progress collections" are " payments received from customers as deposits before the associated work is performed or product is delivered." There are two factors here. First, GE began shipping against an "enormous" amount of progress collections in renewables made in the fourth-quarter. This is not an issue per se, but it does suggest that fourth-quarter cash flow was somewhat inflated by progress collections.
Second, some big orders, particularly in the Middle East, failed to close in the first-quarter. Bornstein expects most will financially close in the second quarter, but until they do investors will be cautious.
Image source: GE Energy Connections
Contract assets
When a company has a right to payment for a product or service already transferred to the customer which is conditional on something other than time, it's called a contract asset.
The $300 million shortfall here comes from two areas. First, $200 million comes from "long-term equipment contracts" where the timing of "our revenue recognition milestones differ." Bornstein expects the CFOA to catch up as "we execute against the contract." Second, $100 million comes from services contracts from which GE has incurred costs and booked revenue, but hasn't billed the customer yet.
While these issues are not problems in themselves, they do suggest that GE's revenue was somewhat inflated in the quarter.
Does it matter?
Yes. First, the issues with receivables and progress collections in power, and particularly in the Middle East, speak to possible challenges GE is having growing its power business. Is the company diluting the quality of its revenue by chasing business it would otherwise not take on board? Second, the shortfall in contract assets suggests GE's revenue growth might be inflated.
All told, GE still has a lot of convincing to do in 2017.
