At an investor conference last week, General Electric (GE 2.01%) CEO Larry Culp warned that the conglomerate's industrial free cash flow will likely be negative in 2019. Investors weren't pleased with the news.
Indeed, GE stock plunged 12% in the two days after that revelation. This completely erased the gains from a late-February rally, which was sparked by news that Danaher had agreed to buy the company's biopharma business for a hefty $21 billion.
The outlook for negative industrial free cash flow this year certainly isn't good news for GE stock. However, investors are probably overreacting. This guidance isn't entirely a surprise -- and it doesn't have any bearing on the company's long-term cash flow potential.
Check out the latest earnings call transcript for General Electric.
Guidance comes trickling out
Due to recent management changes and the general upheaval in its business, General Electric didn't provide guidance for 2019 when it reported its fourth-quarter results in late January. At the time, Culp warned investors of several headwinds that would hurt free cash flow this year. These included changes in working capital, restructuring costs in the struggling power segment and at the corporate headquarters, and "various nonrecurring investments and commitments." Nevertheless, GE stock surged 12% on the day of the earnings release, as there were no ugly surprises in the earnings report.
GE will present its full 2019 forecast on March 14. However, in his presentation last Tuesday, Culp provided some more details beyond what he revealed on the earnings call.
Most notably, he stated that industrial free cash flow is on track to be negative this year -- down from $4.5 billion in 2018. The power segment, which burned $2.7 billion of cash in 2018, is likely to lose even more money in 2019. Culp also reiterated that GE will ramp up the pace of restructuring at its headquarters and in its underperforming divisions this year. As a result, it will incur cash costs that will dent free cash flow.
GE's power segment is bleeding cash faster than ever. Image source: General Electric.
Culp did note that the cash flow headwinds impacting GE will taper off significantly in 2020 and 2021. However, he didn't provide a more detailed forecast of how much free cash flow might rebound over the next two years.
The short-term and long-term outlooks are not the same
Not surprisingly, bears saw Culp's 2019 free cash flow forecast as a clear indication that GE stock had rallied too far since bottoming out below $7 in December.
However, in the short run, General Electric can withstand some negative free cash flow. The company substantially reduced its debt in 2018, largely through a series of asset sales. It brought in $2.9 billion last month in conjunction with combining GE Transportation with Westinghouse Air Brake Technologies (Wabtec). The biopharma sale -- scheduled to close near year-end -- will raise another $21 billion. Finally, GE owns shares of Wabtec and Baker Hughes, a GE Company worth about $17 billion combined.
Meanwhile, GE's short-term cash flow issues don't have much bearing on its long-term cash flow potential. For example, the power segment is hemorrhaging cash right now partly because of the cost of rightsizing the business. Management wouldn't be spending so much time and effort on fixing the power business if it couldn't be salvaged. Just getting back to breakeven would boost cash flow by billions of dollars. Restructuring today should also lead to lower corporate overhead and a better cost structure in the renewables segment going forward.
Finally, GE Aviation -- by far the company's most valuable business -- is still in the early innings of its growth. Annual free cash flow from this segment is likely to grow by billions of dollars over the next few years.
Long-term investors will be rewarded
There are a lot of moving parts at General Electric right now, and the uncertainty has taken a toll on GE stock. Many investors and analysts appear to be obsessed with what's happening to GE's profit and cash flow this quarter or this year and are ignoring the long-term value in its businesses.
If GE were facing a cash crunch, a short-term focus might be justified. But with tens of billions of dollars rolling in from asset sales and selling GE's shares of other companies, it's clear that the company has ample cash at its disposal. A recent presentation by the new leaders of GE's insurance business also showed that it is highly unlikely that General Electric will need to make massive additional unplanned contributions to its reserves (another big fear of some investors).
GE Aviation alone is probably worth significantly more than the current value of GE stock. Right now, that value isn't obvious to investors looking at GE's high-level financial results, due to the ongoing restructuring process, problems at the power business, and the company's asset sales. Luckily, things should settle down over the next two to three years. Investors who hold GE stock until then -- or longer -- are likely to be rewarded.
