Larry Culp is a CEO more used to underpromising and overdelivering than the other way around. It might seem simple enough -- just lowball guidance and declare victory when the numbers roll in -- but it's something that former General Electric (GE +4.06%) CEOs Jeff Immelt and John Flannery found impossible to do. So the hiking of guidance in the second quarter should be welcomed by investors, even if it was accompanied by a less-than-stellar performance on the operational front. Let's take a closer look at the puts and takes of GE's second quarter.
General Electric raises guidance
While Culp is known for outperforming expectations during his time at Danaher, now-departing GE CFO Jamie Miller's tenure will be remembered for a series of guidance cuts due to overly optimistic and inaccurate projections. Her departure will probably improve investor confidence in GE's ability to hit its near- and long-term targets -- something that Culp's gravitas helped buy for GE.
Turning to what's new in the current headline guidance, the table below shows the main changes.
| GE Full-Year Guidance |
Current |
Previous |
|---|---|---|
|
Revenue growth |
Mid-single digits |
Low to mid-single digits |
|
Adjusted EPS |
$0.55 to $0.60 |
$0.50 to $0.55 |
|
Industrial margin |
0 bp to 100 bp |
0 bp to 100 bp |
|
Adjusted industrial free cash flow |
($1 billion) to $1 billion |
($2 billion) to $0 billion |
|
Cash used for restructuring |
+$1.5 billion |
+$2 billion |
Data source: General Electric presentations. bp = basis points, where 100 bp = 1%.
A few points of note:
- Revenue growth expectations have been increased, but margin expectations remain the same. This is in line with some underwhelming margin performance in the second quarter.
- There is a $1 billion improvement at the midpoint of industrial free cash flow (FCF) guidance, but $500 million of it is attributable to a decrease in cash used for restructuring.
Clearly, there are some gaps in the numbers here that need explaining.
Free cash flow in 2019 is a mix of headwinds and tailwinds
Starting with the all-important FCF guidance -- the source of most investor skepticism over the stock -- Miller said the reasons for the increase were "improvements in Power," lower restructuring charges, earnings improvements, and "better visibility at the half."
We've already seen that GE is set to use $500 million less in cash due to lower restructuring expenses. That's good news. It's even better news that most of the remaining $500 million in improvement appears to come from the power segment.
For example, the power segment was the only one that saw an improvement in underlying cash flow guidance for 2019, and during the earnings call, Culp talked about the $1 billion improvement in industrial free cash flow: "That we are improving the range by $1 billion for the year, I think it is appropriate to look at that and say that the bulk of that is coming out of the Power performance."
The power segment saw a cash outflow of $2.7 billion in 2018, and management previously forecast for the figure to be worse in 2019, but the updated guidance is for "flat to down."
Image source: GE website.
The 737 MAX impact
Moreover, it's worth noting that the grounding of the Boeing (BA +2.98%) 737 MAX is significantly impacting GE's cash flow. As a reminder, GE has a joint venture with Safran, called CFM International, that manufactures the LEAP engine for the Boeing 737 MAX and Airbus A320 family.
Discussing the impact of a cut in 737 MAX production and consequently LEAP engines, Miller outlined how "year-to-date it impacted our cash flow by about $600 million or $300 million per quarter." Moreover, she disclosed that "if the plane remains grounded, we anticipate a negative impact of roughly $400 million per quarter."
The issue wasn't lost on the analysts on the earnings call, with Gordon Haskett's John Inch asking if the cash drag from the cut in Boeing 737 MAX production of $1 billion to $1.1 billion "is in your number." Miller replied that "The impact I talked about before is in our guide" and that it was "just a delay in cash timing." In other words, when Boeing starts delivering 737 MAXs again, GE will get cash for the engines. Provided the 737 MAX gets back into service, the only likely effect will be a shift in cash flows -- the timing of which depends on when the 737 MAX resumes service.
All told, given that October has been penciled in as a date for the return of the 737 MAX, it looks likely that GE will end up taking a significant hit to cash flow in 2019 -- although to be fair, it looks likely the cash flow could be shifted into 2020.
How should investors think about GE's earnings?
The key takeaway is a positive one. GE's operational performance may not have been great, and half of the increase in FCF guidance is simply down to less restructuring activity. But let's put it this way: What would the market reaction have been if Culp had come out and said FCF would be $1 billion worse than GE had previously guided to?
Moreover, any sign of stability at Power should be taken as a positive by investors, not least because it's helped the company start to outperform expectations. That's a good thing.
