It's no secret that General Electric Company (GE 5.54%) has had a difficult 2018, and management's earnings targets appear to be under pressure. However, to investors who are willing to look beyond the near term, the stock may look like a good value.
In this context, let's take a look at three opportunities GE has to turn its fortunes around.
A GE Aviation GE9X engine in development. Image source: General Electric Company.
Improving power margin
GE certainly has work to do if it's going to hit its target of around $1.95 billion in power segment profit in 2018. By my calculations, GE is going to have to improve power margin to nearly 8% or above in the second half in order to get there, but segment margin was just 4.7% in the first half.
No matter, a demonstration of sequential improvement in power segment margin -- CEO John Flannery is aiming to get power margin above 10% in the next few years -- might be enough to satisfy investors that the company is on track to stabilize its problem segment.
At the Electrical Products Group (EPG) conference in May, CEO John Flannery outlined three areas in which the power segment could improve margin in the future, from 5.6% in 2017 to 10% or more:
|
How GE Plans to Improve Margin |
Planned Improvement (Basis Points) |
|---|---|
|
Rightsize footprint and base cost |
300 to 500 bp |
|
Maximize value of transactional service |
100 to 200 bp |
|
Improve equipment margins (Gas Power Systems, Grid) |
100 to 200 bp |
Data source: General Electric Company presentations. 100 basis points = 1%.
It's probably optimistic to expect too much from equipment margins, as they continue to be pressured by end markets that GE and key rival Siemens AG see as remaining weak for the next couple of years.
On a more positive note, speaking on the second-quarter earnings call, CFO Jamie Miller confirmed GE Power was on track to reduce structural costs by $1 billion for the full year -- $566 million of structural cost was taken out in the first half.
However, the biggest difference could come from improving performance in GE Power transactional services. At the investor update in November, GE Power CEO Russell Stokes argued that its contract service agreements (CSAs) -- long-term service agreements attached to new equipment sales -- had "been running fine," but GE needed to fix its transactional service business.
As such, GE Power has focused on increasing "visibility to transactional outages," as 75% of the installed base of smaller turbines are managed on a transactional basis.
Indeed, Miller argued on the second-quarter earnings call in July:
We have visibility to 90% of the non-CSA GE units over the last year, and have initiated commercial actions on 80% of these units. We are focused on gaining traction and winning new business, with transactional revenues up 5% for the first half. We expect to see improvement in the second half, especially as we move into the fourth quarter.
All told, if GE can demonstrate power margin progression through a combination of cost cuts and improving its transactional services business, then the pathway to 10% margin becomes a lot clearer -- something to keep a close eye on.
Cutting head-office costs
GE's restructuring plan involves stripping down the company to three main businesses: power, aviation, and renewable energy. Here GE has an opportunity to significantly cut corporate costs, and focus on improving productivity in the remaining businesses.
Indeed, when Flannery announced the plan, he also outlined an intent to reduce corporate costs by at least $500 million by 2020, equivalent to around $0.05 in earnings per share in today's figures. If newly appointed board member Larry Culp helps GE replicate the kind of business performance he generated as CEO of Danaher Corporation, then GE investors can expect significant improvements in productivity.
Aviation upside
The aviation segment is set to generate at least three times the earnings of GE Power in 2018, and more than ten times that from GE Renewable Energy. Moreover, it's well-known that the LEAP engine (produced by CFM International, a joint venture between GE Aviation and France's Safran Aircraft Engines) is set for good long-term growth.
For reference, the LEAP engine is the sole engine option on the Boeing (BA 2.63%) 737 MAX, and one of two options on the Airbus A320neo. The two aircraft are set to dominate the narrow-body market for years to come, and GE has a great opportunity to profit from servicing the LEAP engine in the long term.
GE also has the sole engine (GE9X) on the Boeing 777X -- a new wide-body aircraft that Boeing hopes will drive a pickup in wide-body demand in the coming decade. Indeed, Boeing's current long-term outlook calls for global wide-body deliveries to increase by 8,200 over the next 20 years -- the current global passenger fleet stands at around 4,100.
If the 777X is as big a success as Boeing hopes, analysts could be forced to raise long-term expectations for GE Aviation profit growth. That could lead to a positive rerating for the segment, and thus GE as a whole -- so investors in GE should closely follow what Boeing is saying about potential order growth for the 777X.
The takeaway for GE investors
The company's near-term prospects are under pressure, but that doesn't mean the company doesn't have substantive opportunities to improve performance in the long term. In other words, if you are prepared to be patient and stomach some potential near-term disappointment, the stock could reward you in the long term.
