There's no way to sugarcoat this. The third-quarter results from General Electric Company (NYSE:GE) were horrible, and investors shouldn't underestimate the magnitude of the task ahead of new CEO Larry Culp. While the expansion of the Securities and Exchange Commission's ongoing investigation of GE's $22 billion goodwill charge -- the Department of Justice is also looking at it -- will grab the headlines, the reality is that GE's operational performance was weak too.
Moreover, Culp hasn't announced any significant changes to the company's strategic direction. Let's take a look at the key takeaways from a poor set of results.
GE slashes its dividend
The quarterly dividend was cut from $0.12 per share to just $0.01 per share -- presumably to allow funds that invest only in dividend-yielding stocks to continue to hold the stock.
While it will come as a disappointment to many, the move makes perfect sense given that GE will miss its free cash flow (FCF) forecast for 2018 and needs resources in order to turn the company around. As Culp noted, it will allow GE to retain $3.9 billion of cash per year. Investors should welcome this move on the whole.
GE's guidance cut was without detail
The company's need for cash is all the more apparent in light of CFO Jamie Miller's remarks that the problems in the power segment "will cause us to significantly miss our full year cash flow and earnings targets." For reference, GE's last formal guidance for earnings per share was in the range of $1-$1.07 and FCF of around $6 billion -- numbers that GE was always going to find hard to meet.
Unfortunately, management shied away from putting numbers to its fourth-quarter guidance, with Miller mentioning "deal closure delays and uncertainties" in power, while Culp talked of wanting to give guidance with "conviction and confidence."
In a sense, that's a good thing, because the one thing Larry Culp must start by doing is delivering on guidance -- something the company has consistently failed to do n the last couple of years.
Restructuring GE Power
Culp also announced an intent to restructure GE's ailing power segment into two operating units. The first will focus on gas power equipment and services, and the second will be a portfolio of steam, grid, nuclear, and power conversion businesses.
The move won't grab headlines, but it does open GE up to the possibility of partnering or even selling one of the two units -- as Culp noted during the earnings call, "everything is on the table at power."
Power's performance was dismal
Let's put this into context with some numbers. As you can see below, GE isn't going to get anywhere near its previous implied guidance for 2018.
Year to Date
Implied Full-Year Segment Guidance
In the company's defense, GE had to deal with a failure on a turbine blade in the quarter, meaning power had to record $240 million in warranty and maintenance reserves.
However, in answering a question from Wolfe Research's Nigel Coe, Miller disclosed that "we saw about $400 million of project reserves and other execution issues and about $150 million of just some other execution issues," but then claimed that outside of these issues, "power probably came in about as expected operationally with the exception of these charges that are incrementally flowing through."
At which point investors are entitled to wonder what GE would have reported if power hadn't performed "as expected operationally," and just what the $550 million worth of "other execution issues" were.
It's true that GE's aviation segment had a standout quarter, with profit up 25% to $1.67 billion. With segment profit of $4.74 billion in the first nine months, it's well on its way to meeting the implied target of around $6.2 billion for the full year.
However, management didn't upgrade its guidance for 15% profit growth for aviation. Moreover, aviation was likely to have a good quarter because it's tracking behind its full-year target for production of 1100-1200 LEAP engines. The sale of the engine is a loss leader, but GE makes money on aftermarket and servicing. So unit sales negatively affect profit margins. So paradoxically, producing more LEAP engines eats into profitability.
Looking ahead at the fourth quarter, LEAP engine production will have to ramp up to around 360-460 (from 303 in the third quarter) in order to hit target, and this implies some margin contraction in the coming quarter.
Healthcare and renewable energy
Meanwhile, healthcare's organic revenue growth of just 3% is good, but doesn't suggest much upside to management's targets for 2018, and ongoing pricing erosion in renewable energy led to a collapse in segment margin in the quarter to 2.1% -- renewable energy segment profit is down 51% in the first nine months, to just $220 million.
GE backs off its debt-to-earnings-reduction plan, a little
The extra cash from cutting the dividend needed to shore up the balance sheet is likely to come in handy, not least because Miller appeared to back off the company's plan to reduce its net-debt-to-EBITDA ratio by 2020. A ratio of 2.5 times is typically seen as suitable for investment-grade debt by credit rating agencies.
Goldman Sachs analyst Joe Ritchie asked if the timing of the plan had changed, and Miller replied, "We intend to reach net debt to EBITDA of 2.5 times. We plan to achieve that over time with substantial progress through 2020."
No equity raise, broadly sticking to plan
Culp's track record at Danaher (NYSE:GE) inspires confidence, so when he stated that "we have no plans for an equity raise," investors can take it at face value. Analysts, such as JP Morgan's Steve Tusa, have suggested GE needs to raise equity -- an act that would dilute the ownership of the company for existing shareholders -- so Culp's comment is reassuring.
At least for now, Culp is broadly sticking to Flannery's plan. Indeed, anyone hoping he would announce changes to the current plan to separate healthcare and sell its remaining stake in Baker Hughes, a GE Company (NYSE:GE) would have been disappointed. Culp said he would hold to the exit plan for Baker Hughes and continued to believe "healthcare operating in an independent form is probably what is best for that business."
The final takeaway
Investors should be in little doubt that Culp has a large task ahead. The earnings report was even weaker than many expected. The aviation numbers were strong, but possibly flattered by less-than-expected LEAP production, and management didn't raise full-year segment guidance. Cutting the dividend is good news, as is the lack of a need to raise equity, but GE needs to demonstrate progress on improving its balance sheet.
Looking on the bright side, Culp appears to be following the mantra of putting GE's house in order before issuing realistic guidance. That's usually the first step in a recovery, and hopefully, he will succeed and restore GE to its former greatness. It will take time.