The departure of long-serving CEO Jeff Immelt leaves General Electric Company (GE 2.58%) investors wondering what's next for the company. In reality, it's too much to expect any major changes in the strategic direction of GE, but new CEO John Flannery will begin his tenure facing concerns that the company's stated earnings targets -- specifically, $2 in operating earnings by 2018 -- will have to be taken down. Let's take a closer look at what lies ahead for Flannery.
Immelt's $2 worth
Having tied himself to the mast over the earnings target, Immelt appeared to back off it at the Electrical Products Group (EPG) conference at the end of May. In saying that the $2 target would be "at the high end of the range, and our job now is to take more cost out," he signaled to investors that it was no longer the key benchmark against which he wanted GE to be measured.
Instead, he repeatedly reiterated the new mantra for 2018:
- Organic revenue growth in the range of 3% to 5%
- Operating margin expansion of 100 basis points (where 100 basis points equals 1%)
- Free cash conversion from net income of 80% to 90%
These somewhat less ambitious targets leave Flannery with an easier task, but there's still the issue of earnings guidance.
The matter was discussed on the CEO succession call with Flannery promising a "comprehensive review" of GE's businesses with an update due in the fall. Flannery later confirmed his update would cover what Credit Suisse analyst Julian Mitchell called "the medium-term earnings outlook." In other words, don't be surprised if Flannery adjusts 2018 earnings target in the fall.
If he does end up lowering the earnings guidance, then it would hardly come as a surprise to the analyst community because the consensus is for GE to earn $1.89 in 2018.
What Flannery needs to look at
There are three major considerations that the new CEO -- his tenure is effective on Aug. 1 -- and investors need to consider about GE's prospects.
First, the main reason GE missed the revenue guidance it gave at the beginning of 2016 was mainly because of disappointing oil and gas performance. Of course, GE wasn't the only company to be overly optimistic in 2016 regarding its energy based revenue, but it stands out due to actively increasing its oil and gas capital spending exposure with the intended Baker Hughes merger.
Moreover, Immelt struck a cautious note at the EPG conference when he said, "So I think you've got to work a number of scenarios, but I don't think we'd do you any favors unless we underwrite 2018 assuming resource markets are stable. If you do that as your underwriting case, $2 will be at the high end of the range."
In other words, any weakness in oil and gas capital spending -- largely contingent upon energy price movements -- could hit the company, especially considering the Baker Hughes deal.
Second, power is one of GE's traditional core strengths and, unfortunately, it appears to be coming under pressure. The segment is set for a flat year in terms of gas turbine shipments. The following chart shows how gas turbine orders have slowed in the last four quarters.
Moreover, GE's fourth quarter of 2016 was impacted by weaker-than-expected turbine shipments and a large part of the cash flow shortfall in the first quarter was related to issues with the power segment. Suffice it to say that the power segment isn't firing on all cylinders right now.
Difficulties meeting the numbers
Third, having already mentioned that GE's organic revenue growth of 0% (1% including the acquired Alstom assets) missed its original 2016 organic revenue growth guidance of 2% to 4%, it's worth noting that the good news in 2016 came from non-core activities. For example, dividends from GE Capital came in at $20.1 billion for 2016 compared to an initial forecast for $18 billion, while dispositions added $4 billion to cash flow compared to an initial forecast for $2 billion to $3 billion.
The better-than-anticipated cash flow led to buybacks of $22 billion in 2016 compared to management's initial forecast for $18 billion, helping boost earnings per share in the process due to the reduced share count. The point being that GE can't rely on GE Capital dividend and disposals in order to meet its earnings targets in the future.
General Electric Company's outlook
Ultimately, it looks like investors will have to wait until the fall before Flannery goes into more detail about the future of the GE portfolio or medium-term earnings guidance. However, given the pressure on GE's earnings and cash flow, it wouldn't be a surprise if the company's 2018 guidance is taken down, something investors should look out for.
Clearly, any downward revision to guidance would be a short-term negative, but the key long-term consideration will be whether the issues in oil & gas and power are cyclical or structural in nature? If it's a cyclical issue--as in weak end market spending, something which seems to be the case--then any cut in guidance shouldn't unduly worry long-term investors. However, cautious investors should wait to hear what Flannery says in the fall.