General Electric Company (GE 1.09%) stock is down 51% in 2018, and retail investors must be wondering what on earth has happened to the former stock market darling. The startling decline has attracted many value investors trying to pick a bottom in the stock, but aside from the short-lived rally after Larry Culp was appointed CEO at the start of October, it's been downhill all the way. What's gone wrong, and what can be learned from it?

Three reasons why GE has declined in 2018

Three main, and closely related, factors are responsible for the decline:

  • Significant reduction in earnings and free cash flow (FCF) expectations.
  • Erosion of credibility with investors due to management providing inaccurate guidance.
  • Concern over future prospects, particularly over the ailing GE power segment and GE capital, and over SEC investigations. 
A declining stock chart.

Image source: Getty Images.

Earnings and cash flow weak

Management started the year forecasting earnings per share in the range of $1 to $1.07 and free cash flow of $6 billion to $7 billion. To put these figures into context, if GE were to hit the midpoint of these ranges, based on the current price of around $8.80, the 2018 P/E ratio would be just 8.3 times earnings and the FCF yield (FCF divided by market cap) would be a whopping 8.7%.

Unfortunately, the bad news is that GE won't come anywhere near those figures in 2018. According to CFO Jamie Miller on the third-quarter earnings call, "With respect to power, the issues will persist longer and with deeper impact than we had initially expected, which will cause us to significantly miss our full year cash flow and earnings targets."

There's the smoking gun. The main reason for GE's decline is its deteriorating earnings and cash flow, mainly due to its power segment -- an issue that came to the fore in the company's horrible third-quarter earnings report

Erosion of credibility

It's part of management's responsibility to give company outlooks and accurately inform investors of market conditions and risk. It's fair to say that former CEO John Flannery and Miller didn't do a great job of it in 2018.

After a first quarter (April) in which management cut its implied guidance for power segment profit by $500 million (around $0.05 in EPS), Flannery merely guided investors toward the low end of the $1-$1.07 EPS range and left FCF guidance untouched

Fast-forward to the second-quarter earnings in July, and management stuck to the EPS guidance range, although FCF guidance was adjusted to just $6 billion. As noted at the time, the analyst consensus was for $0.95, and there were doubts about GE's ability to hit earnings targets

You already know what happened in GE's third quarter

Unfortunately, the problem of inaccurate guidance is that its impact isn't limited to just a quarter or two of weakness in the eyes of investors. For example, shareholders are entitled to ask, "If we aren't confident in your near-term guidance, then why should we believe in your plan to reduce debt-to-earnings levels by 2020?" 

Future prospects

The third major issue is the concern over the company's future earnings and cash flow prospects. It didn't help that management didn't give guidance on the third-quarter earnings call, but then again Culp has only been in the CEO position since the start of October, and given the damage to credibility caused by management's previous guidance, it makes sense for Culp to ensure he gives guidance with, in his words, "conviction and confidence."

The ongoing deterioration in GE power's end markets is obviously a major concern. Moreover, exiting GE transportation (through an imminent merger with Westinghouse Air Brake Technologies), separating GE healthcare (planned for 2019), and selling lighting businesses will help raise cash and reduce debt, but these three businesses are currently GE's strongest cash converters.

For example, GE previously forecast that healthcare, transportation, and lighting would convert income into FCF at a rate of above 100% in 2018, but aviation conversion is expected at 80%, with renewables at 80% to 100%. In short, GE is selling its highest cash converting businesses and keeping what are currently its lowest cash converting businesses.

It's not hard to see why the market is fretting over GE's cash-generating capability going forward.

What's next for GE?

There's little GE's management can do about deteriorating power markets, but it can do a better job of giving guidance and assessing end market conditions in power. That will restore credibility and give confidence in GE's turnaround plan.

Unfortunately, investors are going to have to wait until Culp is ready to give more details on his strategic plans, and this will leave the company susceptible to negative speculation over the FCF generation of the remaining GE company after healthcare and transportation are separated.

However, if Culp can produce a credible plan to increase FCF, then GE's stock will start to look like a very good value.