This article was updated on April 6, 2018, and originally published on Nov. 15, 2017.
On Nov. 13, 2017, U.S. industrial giant General Electric (GE -2.25%) held an investor day event at which new CEO John Flannery unveiled his strategy for the company. The stakes were high, as GE had released a terrible earnings report a month earlier and slashed its 2017 earnings per share forecast.
However, investors didn't take kindly to what Flannery had to say at the 2017 investor day -- especially his decision to slash GE's dividend by 50%. As a result, General Electric stock fell 13% in the next two days. It tumbled another 25% by the beginning of April 2018, due to growing worries about GE's long-term liabilities and the threat of a U.S.-China trade war. After this big plunge, General Electric stock is starting to look like an interesting long-term investment opportunity.
Getting smaller -- and simpler
General Electric is one of the last big conglomerates in the U.S. Recently, its complexity has been a problem. The company has allowed problems to fester in many of its businesses because management's attention has been spread too thin.
Flannery intends to fix this issue by narrowing GE's focus. Right now, the company reports revenue and profit from seven different segments, excluding its GE Capital financing business. These are: Power, Renewable Energy, Oil and Gas, Aviation, Healthcare, Transportation, and Lighting. Going forward, Flannery wants GE to focus on the power (including renewables), aviation, and healthcare markets.
Power will be one of GE's three main businesses going forward. Image source: General Electric.
To execute this shift, General Electric is planning for roughly $20 billion of divestitures by the end of 2019. This will include the entire transportation and lighting businesses, along with pieces of other business segments.
Additionally, GE will eventually exit its investment in Baker Hughes, a GE Company (BKR -1.35%), which was formed in mid-2017 from the merger of GE's oil and gas business with Baker Hughes. However, GE isn't allowed to sell its 62.5% stake in the "new" Baker Hughes until at least July 2019, so this part of its business will stay put for now.
The planned divestitures will enable management to devote its full attention to Flannery's stated priorities of free cash flow production and capital allocation. If these efforts succeed, GE should return to solid earnings growth after 2018.
Wall Street seems to hate the stock now
While retail investors were particularly upset by GE's deep dividend cut, Wall Street analysts have had other gripes about the company's turnaround plan.
First, some analysts have been calling for a full breakup of General Electric. However, while the company is slimming down, at the end of the day, it will still be a conglomerate. As a result, these analysts believe that GE isn't being bold enough in reinventing itself.
Second, several analysts were disappointed by GE's cost-cutting targets. Given the depth of problems in the power segment in particular, the target of removing $1 billion of structural costs from the power business in 2018 seems insufficient.
Third, despite having fallen more than 55% from its 52-week high, General Electric stock isn't dirt cheap. The company's guidance calls for adjusted EPS of $1.00-$1.07 in 2018, but analysts on average expect adjusted EPS of just $0.96. Even at its 52-week low of $12.73, General Electric stock traded for about 13 times forward earnings.
The best businesses are growing in importance
Despite these disappointments, there is one major reason for optimism: General Electric's two best-performing businesses are growing in importance to the company. In a slimmed-down version of GE, they would shine through even more.
The smaller of these is the healthcare unit. Flannery himself turned GE's healthcare division around a few years ago, and it is now delivering steady revenue and profit growth. In 2017, its segment profit rose 9% year over year to $3.45 billion.
GE's best business of all is its aviation division. GE, including its joint venture CFM International, is the largest jet engine manufacturer in the world. This is a growing business, thanks to rising global demand for air travel and GE's cozy relationship with Boeing (BA -0.88%).
GE engines will power Boeing's next-generation 777X, and roughly 65% of buyers for the 787 Dreamliner are choosing the GE engine option for that plane. A planned increase in the Boeing 787 production rate and growth of the installed base (which drives high-margin service revenue) will support growth in this wholly owned business over the next few years.
The CFM joint venture business is even more promising. Its new LEAP engine is the exclusive powerplant for Boeing's 737 MAX and has more than 50% market share on Airbus' competing A320neo. The result is a backlog of roughly 14,000 LEAP engine orders that is still increasing. This virtually guarantees a long period of growth, with engine production ramping up over the next few years and service revenue following thereafter.
Strong demand for the 737 MAX is boosting GE's aircraft engine sales. Image source: Boeing.
In 2017, the aviation business posted a segment profit of $6.64 billion, up 9% year over year. GE expects another high-single-digit profit increase for the aviation segment in 2018.
In the fourth quarter of 2017, aviation and healthcare together drove 83% of GE's industrial segment profit, up from 61% in the first half of the year. Thus, the healthiest parts of GE are quickly becoming its main profit drivers, which bodes well for an eventual return to profit growth for the company.
A stock for patient investors
Even if the aviation and healthcare businesses continue to grow steadily, GE's turnaround will take time. Flannery believes that GE will be able to improve the power business significantly in the next year or two, but a full turnaround will take longer. In the meantime, segment profit for GE Power is expected to fall by another 25% in 2018 as the company cuts production to align with the current demand environment.
However, from that lower 2018 baseline, GE will be well positioned for long-term earnings growth driven by the secular tailwinds supporting its aviation and healthcare segments. Margin improvement in the power business -- whenever it comes -- will just be icing on the cake.
GE will also be able to improve its balance sheet with the proceeds from its asset sales. If it sells off its Baker Hughes stake in a few years, that will bring in an additional windfall. Based on a $30 stock price for Baker Hughes, GE's portion of the company would be worth more than $20 billion. With oil prices on the rise and merger synergies on the way, that value could increase significantly.
General Electric stock could recover much of its recent losses over the next few years if GE gets earnings growing again as expected. As a result, I have been gradually accumulating shares since December 2017. General Electric shares will likely remain volatile as investors continue to digest management's turnaround plan, so this stock is a prime candidate for "averaging in": i.e., buying shares in smaller chunks over a period of several months.
