Does GE's Turbine Failure Matter?

By now most General Electric Company (GE -1.75%) followers will be aware that its HA-Class gas turbine, the flagship product of GE Power, had a failure that caused Exelon (EXC 0.71%) to shut down the turbine along with three others as a precaution. There's no doubt that this is going to negatively impact GE, but how relevant is it, and what should investors make of it?

The HA turbine matters

The heavy-duty gas turbine is actually one of the success stories of GE Power in recent years, and there's a case for arguing that if it hadn't been so successful, then GE's power segment would be in even deeper trouble. According to GE Power CEO Russell Stokes on his LinkedIn account, "In 2017, we received a majority of global Heavy Duty Gas Turbine awards, with the HA leading in its space."

The GE HA turbine. Image source: GE.

Moreover, GE needs every gas turbine order it can get in the current deteriorating environment. A combination of weaker than expected gas turbine demand in 2017 and a dismal outlook for 2018-2020 from both GE and Siemens has caused GE to cut its power segment guidance by some $500 million this year alone. That's worth about $0.05 in earnings per share and is creating challenges for its full-year guidance for EPS of $1 to $1.07.

The chart below shows how GE has lowered its guidance for heavy-duty gas turbines in 2018.

Data source: General Electric Company presentations.

The HA-turbine -- GE has received 82 orders and shipped 51 units to date -- is a key product and the last thing GE needs to hear about right now is costly repairs to equipment shipped and compensation payments to customers.

What actually happened

That said, it's important not to sensationalize the issue because GE and Exelon have both expressed confidence that the issue is fixable.

Stokes took to his LinkedIn account to write an article saying, "We identified an issue that we expect to impact our HA units. It involves an oxidation issue that affects the lifespan of a single blade component. " He continued saying, "We have identified a fix and have been working proactively with HA operators to address impacted turbines."

More recently, a GE press release stated: "The component is only used in stage-one blades in GE's highest-efficiency turbines — HA and 9FB, one of the HA's predecessors and a legacy fleet that comprises less than one percent of the Company's global gas turbine fleet."

Furthermore, a Bloomberg article quoted Exelon COO Mike Pacilio as saying the two affected sites -- Wolf Hollow and Colarado Bend -- would be working again the following week and GE had a plan to repair the issue later in the year.

A market overreaction

The issue is a disappointment, and it will surely cost GE money -- not least to repair the issues with turbines already shipped and possibly make adjustments to current HA production -- but investors will have to wait for management to outline what the one-off costs are likely to be.

If it does turn out to be a minor issue that merely involves some one-off costs -- worth no more than, say, a few cents of EPS -- then there's a case for arguing that the near-4% drop in share price (nearly $6 billion in market cap) since the news broke is an overreaction.

GE needs power for a recovery

The deeper issue is that the problem with the HA-turbine is likely to obscure the view on margin progression at GE Power, which is something the market needs to see from GE.

It's important for two reasons. First, a recovery in the power segment is an integral part of GE's plan to reduce its net debt-to-earnings ratio in line with what credit rating agencies typically expect for investment-grade debt.

Second, if GE is going to hit its earnings targets for 2018, then it's probably going to need margin expansion in its power segment -- not least because first-half segment profit was just $694 million when the full-year forecast is for $1.95 billion.

What really matters to investors

In addition, during the second-quarter earnings call CFO Jamie Miller described gas turbine and aero-derivative orders as "moving out to the second half." Miller continued, "We have visibility to a solid pipeline of activity in the second half. However, the timing of closing on these orders remains difficult to forecast."

GE was expecting, and needs, a better second half for power, and also to make some progress toward the 10%-plus power segment margin (first-half margin was just 4.7%) that CEO John Flannery previously laid out as a mid-term aim.

Aside from one-off costs and some possible order delays, the biggest problem from the HA turbine issue is likely to be that the hit to profits could obscure the magnitude of the underlying margin improvement at GE Power. This would create even more uncertainty around GE's earnings and cash flow. Investors should look out very carefully for what GE says on the matter during its third-quarter earnings presentation.