Now that General Electric Company (NYSE:GE) has replaced John Flannery with Larry Culp as chairman and CEO, and announced it will fall short of its previously indicated cash flow and earnings guidance, it's surely time for investors to pause and assess what's going on. The post-announcement surge in the share price is partly due to a sense of optimism now that former Danaher CEO Culp is in charge; his record at Danaher explains the respect he has earned in industrial circles.
However, I think there's something more to the price move than simply optimism over Culp. Let's take a closer look.
An unconvincing start
In a nutshell, GE has done a terrible job of turning itself around and managing investor expectations, and the news that there's a clean sweep at the top is hopefully going to lead to a change in how the company manages its affairs. Although it's hard not to feel sympathy for Flannery -- he was dealt a rotten hand -- he was responsible for a large part of the mess.
The skepticism over the commitment to a clean sweep was fueled right at the start of Flannery's tenure. In a move that can only be described as bizarre, the first thing GE did after appointing Flannery was to give then-CFO Jeff Bornstein a promotion to vice chairman. If that weren't strange enough, a few months later it was announced that Bornstein would be leaving.
Flannery takes charge
Flannery then appeared to take charge of events. He decided to ignore the calls to separate the healthcare business, but yielded to the inevitability of a dividend cut and reduced GE's dividend by half to $0.48.
GE's turnaround strategy was then set in place in November 2017. Flannery intended to shore up the balance sheet by exiting $20 billion worth of assets, while relying on the earnings and cash flow from the aviation and healthcare segments to tide the company over while restructuring a power segment ailing from weakening end markets. EPS and free cash flow (FCF) guidance for 2018 were set at $1-$1.07, and $6 billion-$7 billion, respectively.
GE's risky plan
Flannery's plan might have sounded good, but it wasn't decisive enough. Worse, the plan was beset with risk from the start. For example, consider the new dividend of $0.48 per share.
Paying the dividend would require roughly $4.2 billion in cash, but management was only forecasting $6 billion-$7 billion in FCF. Meanwhile, GE's substantial pension deficit needed funding, and based on GE's figures, it needed $2 billion in 2018 alone.
In fact, GE borrowed $6 billion in order to pre-fund its pension for three years. And without the extra debt, the dividend would only barely (or possibly not) have been funded from FCF. Not to mention that the underlying available FCF (free cash flow minus pension funding and dividend) was going to be peanuts compared to what management needed to turn the power business around.
Moreover, in terms of the dividend, the plan had little margin for safety and needed a combination of blemish-free execution and some stabilization in the power segment's end markets.
GE got neither.
Where it went wrong: A timeline for 2018
Fast-forward from the November 2017 reset, and January started with a $6.2 billion tax charge relating to its insurance portfolio. February saw CFO Jamie Miller lowering 2018 earnings expectations to the lower end of the $1-$1.07 range at an investor conference, due to weakening power markets. GE also progressively lowered expectations for gas turbine sales in 2018.
The first-quarter results in April saw GE's management lower power-segment earnings guidance by a whopping $500 million (worth around $0.05 in EPS), but there was still no change to the official EPS and FCF guidance.
The end of June brought the conclusion of Flannery's strategic review, and finally, the decision was made to create a stand-alone healthcare company while separating the remaining stake in Baker Hughes, a GE Company. It was a bid to shore up the balance sheet and reduce debt-to-earnings to commonly accepted levels. And still, no cut to the official guidance.
July brought a disappointing set of second-quarter earnings, with Miller lowering 2018 FCF to $6 billion -- a figure at the bottom, but still within, the original guidance range. There was still no change to the EPS guidance, despite the fact that hardly any Wall Street analyst believed GE would hit even the low end of its EPS guidance range.
Moreover, power-segment conditions continued to deteriorate, and GE's earnings guidance looked increasingly untenable, not least because its key rival, Siemens, was busy lowering earnings and margin expectations for its own power segment.
What Culp must do now
The optimism over Culp's executive abilities is well placed. His first act is likely to be restoration of confidence that GE's management has a handle on restructuring the company for the long term. That starts with being realistic with guidance and the sustainability of the dividend.
In the end, Flannery ended his tenure as Jeff Immelt before him did: stubbornly clinging to guidance that was unlikely to be met, at a time when investors needed to be confident in the direction of the company. Culp just might be the man to turn things around on that front.