Why GE Could Make a Comeback

Over the past year or so, General Electric (GE 7.00%) has had to dramatically reduce its earnings forecasts, while weak cash flow forced the company to slash its dividend by 50%. But despite the ugly headlines, there are some good things happening beneath the surface at GE.

In this episode of Industry Focus: Energy, the team talks about General Electric's two best business segments: healthcare and aviation. Both segments have been posting steady growth in recent years and will benefit from secular tailwinds over the next decade. As a result, they could propel GE to strong earnings growth once the company gets the rest of its house in order.

A full transcript follows the video.

This video was recorded on May 31, 2018.

Sarah Priestley: I count myself in the very lonely camp of being optimistic about GE's prospects. I hope that people at home aren't thinking that I'm crazy, but I think the concentration on the three segments that are currently working for them, with Healthcare, Aviation -- especially Aviation, actually -- is the right thing to do.

Adam Levine-Weinberg: Yeah, I would agree that the Healthcare and Aviation markets, at least, seem quite healthy, and probably undervalued by investors right now. Healthcare, for one thing, is a secular growth industry, just in terms of the aging of the global population. The amount of health spending has been increasing at a very high rate, and there's no reason to think that's going to stop any time soon. GE Healthcare produced a segment profit of $3.5 billion last year, and it's been growing at a mid-single-digit rate. There's really no reason to think it can't keep growing at that rate. It's not extremely fast growth, but it's definitely respectable. They could keep doing that for a decade or more.

Priestley: I read a stat the other day that said that over the next ten years, every day, there will be 10,000 more baby boomers turning 65. And as we know, healthcare costs go up as you get older, so it definitely looks like they're going to be riding this secular tailwind.

Levine-Weinberg:​ Yeah, that's absolutely true. Turning to the Aviation business, that's arguably an even stronger business. GE is the largest engine manufacturer, if you include its 50% owned joint venture, CFM. Air travel is growing extremely rapidly as the global middle class expands. In recent years, you've seen mid-to-high single-digit growth in terms of passenger travel. A lot of that is coming in emerging markets, which have really quite a bit of runway left -- pardon the pun -- for passenger travel growth.

In 2017, Aviation revenue was more than $27 billion, which put it roughly on par with the Power segment. Aviation generated a segment profit of $5.4 billion, adjusted for the new accounting rules that went into effect this year. GE recently disclosed that it expects segment profit to rise at least 15% in 2018 off of that $5.4 billion base. That's going to be past $6 billion just in 2018. And there's quite a bit of room for growth ahead, because GE Aviation gets the majority of its revenue, about $20 billion, from the commercial market. And it has a backlog there of $160 billion. That means that the Aviation business has many years of growth virtually locked in because these orders, in some cases they can be modified, but for the most part, they can't be canceled unless the entire company goes bankrupt.

This growth is being driven primarily by the Boeing 737 Max and Airbus' A320neo family. Together, those two aircraft families have more than 10,000 outstanding orders. There's a huge amount of demand. Even if one airline decides that they don't want planes that they've ordered, there are dozens of other airlines eager to step in. So, GE has a really good position here with about three-quarters of the engine market for those two models combined.

Furthermore, those are both new aircraft families, the 737 Max and A320neo, that have come out within the past three years or so. The new engines have very high costs to build initially, which has put some pressure on GE's cash flow, and under the new accounting rules, also on its earnings. However, over time, those costs will come down substantially. I'm projecting that the cost to build one of these engines could drop by half over the next decade. That's the driving force behind margin expansion for the GE Aviation segment. Between the revenue growth opportunities and the margin expansion opportunities, segment profit could double by the mid-2020s for GE Aviation, putting it well above $10 billion.

Focusing on these two healthy business, Aviation and Healthcare, along with power, which obviously still needs to be turned around, and then a very slimmed-down GE Capital, that really ought to make GE easier to manage and get around that problem where management's being pulled in five directions at once, and therefore nothing's getting fixed at the rate that it needs to be.