GE Earnings Highlight the Stock's Risks

Having previously outlined the four things to look out for when General Electric Company (GE -3.19%) reported earnings, it makes sense to assess the earnings GE actually delivered. On balance, it was a slightly negative earnings report, which only served to highlight that the investment case for the stock is really based on the potential for a turnaround that would begin in 2019. In this context, let's take a look at how the company did in the quarter. 

The bulls and bears are likely to fight over General Electric stock. Image source: Getty Images.

GE earnings and cash flow guidance

There was no change to the full-year EPS guidance of $1-$1.07, a figure which remains above the analyst consensus for $0.95, but CEO John Flannery continues to guide investors toward the low end of that range. However, there was a disappointing -- albeit unsurprising -- change to the free cash flow (FCF) guidance, as Flannery now expects $6 billion in adjusted industrial FCF compared to a previous outlook for $6-7 billion.

Given that earnings were already expected to come at the low end of the range, it stands to reason that FCF should too. Moreover, in a warning sign to the market, CFO Jamie Miller acknowledged that GE was "seeing lower volume impacting our margins primarily at power." In other words, if power continues to decline, then the earnings and cash flow outlook is likely to come under pressure.

GE Power outlook

There's little doubt that the GE Power outlook continued to worsen in the quarter. Restructuring and improving the margin is the single most important thing GE can do for investors, but unfortunately the end market outlook continues to disappoint.

GE Power segment margin was 5.6% in the quarter compared to 10.6% in the same period last year; Flannery wants to get the segment's margin back above 10% in the next few years. It's a disappointing result, and there are three pieces of information that highlight the deteriorating environment even further.

First, Flannery discussed the outlook for heavy duty gas turbines: "[F]irst half trends continue to point to a market less than 30 gigawatts in 2018, which is down from 34 gigawatts last year and 48 gigawatts in 2016." At the Electrical Products Group (EPG) conference at the end of May he outlined a market of 30 gigawatts to 34 gigawatts in 2018, so the latest update is a reduction in expectations.

Second, Miller expects GE to ship 50 gas turbines in 2018. That's a figure at the bottom of the 50-55 range given in April, and significantly below the 65-75 forecast on the investor update in November. 

Third, Miller said that GE had "seen new orders in both gas turbines and aero derivatives moving out to the second half," and then said that "the timing of closing on these orders remains difficult to forecast."

All told, there is a real risk that GE is going to have to take power segment guidance down again.

GE Aviation margin

If power is going to miss management's current guidance, then the company is going to need some help from healthcare or aviation in order to meet full-year earnings guidance -- and remember, GE is guiding to the low-end of its total company full-year EPS range. 

From an aviation perspective, the key question is what impact the ramping of the LEAP project -- an aircraft engine produced as part of a joint venture with France's Safran Aircraft Engines -- will have on margin. Producing more of the engines has a negative impact on margin; and as you can see below, aviation segment profit margin declined in the quarter. Moreover, there's likely to be some margin pressure in the second-half because GE expects to ship 664-764 engines, a significant ramp on the first-half's 436 engines.

Data source: General Electric Company presentations.

GE's full-year guidance for GE Aviation operating profit is for around $6.21 billion, and on the earnings call Miller said that "for the full year we expect Aviation to have positive margin uplift." For reference, aviation margin was 19.9% in 2017, so Miller is expecting an improvement on that number in 2018 in order to meet full-year profit guidance of $6.21 billion.

GE's aviation margin for the half year was 21% and just 19.6% in the second quarter, but with the ramp in LEAP production it's reasonable to expect margin erosion in the second half of 2018. 

The key point here is that, although the aviation segment is doing fine, it won't be a walk in the park to meet margin guidance and management's estimates for LEAP production. In other words, there isn't much leeway for aviation to significantly beat estimates in order to fully offset any further erosion to power guidance if full-year EPS guidance is going to be met.

Good news on cost-cutting

On a more positive note, Flannery said, "[W]e've achieved $1.1 billion in cost out through the first six months and we are on track to exceed our goal of $2 billion," and reaffirmed plans to cut $500 million in corporate costs through 2020.

Flannery has been dealt a difficult hand, but he's doing a good job of cutting costs. 

The takeaway

If you are worried about the near-term outlook, stay away from General Electric stock -- there is a risk that the company won't meet its full-year guidance. Moreover, the recent results and GE Power outlook only served to increase that risk.

There is a case for buying GE stock, but it's based on a turnaround in 2019. As Flannery said, there isn't going to be a quick fix, and buying GE stock requires you to understand that. Patience is required.