Why Investors Should Focus on the Long-Term With General Electric

As Wall Street waits for General Electric's (GE 1.30%) fourth-quarter earnings report, it would be a good idea for investors to take a step back and look at the big picture. Naturally, the market will focus on the near-term outlook and possible updates to the company's debt-reduction plan, but its long-term earnings and cash flow potential are arguably more important. That's key because currently, earnings from the company's two most important segments -- aviation and power -- are being suppressed, but for reasons that should lead to greater profitability down the line. 

What investors should understand about GE

When investors value a stock, they usually look at the long-term earnings and cash flow, so if earnings and cash flow are temporarily suppressed, then it should trade at a premium price-to-earnings ratio, to reflect the anticipated rebound. In this respect, there are two key factors to consider with GE:

• GE Aviation margin and profits are being negatively impacted by the ramp up in LEAP engine production, which will lead to lucrative aftermarket service revenue in a few years time.
• GE Power has been hit by weakness in demand, which has forced management to aggressively cut prices on equipment in order to generate services revenue down the line.

Image source: Getty Images

GE Aviation's bright future

The LEAP engine manufactured by CFM International -- a GE/Safran (SAFRY -0.91%) joint venture -- is on course to become the workhorse of the aviation industry. Not only is it the sole engine option on the Boeing 737 MAX, but it's one of two options on the Airbus A320 Neo -- and those two narrow-body aircraft are set to dominate the market for years to come.

However, as those engines are relatively new, it will be a few years before the aftermarket revenue really starts to kick in. Meanwhile, GE Aviation's margins will suffer as it accelerates production of the loss-making engines. As you can see below, production significantly increased in 2018, and based on management's statements, it will again in 2019 before the increases start to taper off in 2020.

Data source: General Electric presentations. Table by author.

Indeed, the production growth in 2018 was a large part of the reason why management previously forecast that GE Aviation would only convert 90% of its earnings into free cash flow (FCF). 

Putting this together, it's clear that GE Aviation has a margin improvement story going forward, and also an opportunity to improve FCF conversion. In a few years time, LEAP aftermarket revenue will start to roll in; meanwhile, the LEAP production increases will level off, and when more engines are being produced, the unit cost should decline. This all should add up to more earnings and FCF.

GE Power

It's no secret that GE Power faced significant challenges in 2018. End market demand deteriorated more quickly than the previous management was able to adjust, and the company was caught between a rock and a hard place. With renewable energy production growing rapidly and the cost of electricity storage shrinking, demand for GE's gas turbine equipment and services has fallen off a cliff. Just a couple of years ago, GE management thought demand for heavy-duty gas turbines would be above 40 GW a year, but it was below 30 GW in 2018. 

Meanwhile, sales of GE's older-model E- and F-class turbines have come under pressure due to the emergence of newer classes of turbines (G, H and J), among them its own highly regarded HA turbine. It gets worse. All of this happened during the period when GE was integrating Alstom's energy assets, which it acquired in late 2015. Consequently, GE had to heavily undercut its rivals in order to establish market share for the HA turbine -- but the payoff for that will come in the form of services revenue over the longer term.

In a sense, GE Power didn't really have any other option but to take a hit on its power equipment margins in order to support its ambitions for the HA turbine and its Alstom acquisition. Unfortunately, the result was a collapse in earnings and cash flow from GE Power. 

But GE Power is restructuring and downsizing to adjust to the changes in demand. Therefore, it's likely that margins will improve -- and the overall GE Power margin was a miserly 0.3% in the first nine months of 2018. CEO Larry Culp has already told investors that the power division was getting close to bottoming, , and given that Siemens expects margins in the low-single-digit range from its power segment, it's reasonable to expect GE could improve margins in the coming year -- even if demand remains weak.

Looking ahead

All told, GE shouldn't be judged on a single year of earnings and cash flow generation, particularly as its aviation and power business have real opportunities to improve their margins and cash flow. That's a key point to consider when modeling a fair valuation for GE stock.

Check out the latest GE earnings call transcript.