Late last month, General Electric (GE 3.94%) reported better-than-expected results for the second quarter of 2019. GE posted strong organic revenue growth and adjusted earnings per share came in at $0.17, well ahead of the average analyst estimate of $0.12. Most importantly, the company raised its full-year target for industrial free cash flow by $1 billion.
Despite the positive earnings news and guidance update, investors have dumped GE stock, causing it to fall 13% since the earnings report came out. That has pushed the share price back into single-digit territory.
GE stock year-to-date performance data by YCharts.
Indeed, it's clear that General Electric still hasn't managed to win over the investors and analysts who have been skeptical about its prospects for the past few years. However, the case against GE stock seems to be getting weaker with each successive quarterly report.
The bears still don't believe in GE stock
One demonstration of bears' continuing skepticism of General Electric came in a critique of the company that Gordon Haskett analyst John Inch published last week. Whereas GE raised its full-year cash flow guidance, Inch claimed that the company's underlying cash flow performance is worse than it seems. (J.P. Morgan analyst Stephen Tusa has raised similar concerns.)
Inch also questioned whether GE is doing enough to fix its balance sheet. He expressed worry about the company's long-term care insurance liabilities -- which were the source of a $6.2 billion special charge announced in early 2018 -- as well as its pension underfunding and its substantial debt load.
Aside from these specific issues, Inch doesn't see any upside for GE stock even if the company does complete its turnaround effort successfully. He expects free cash flow to rebound to around $0.50 per share, which would be well below the levels seen as recently as two years ago.
Yet the fundamentals are improving
GE is certainly far from having returned to health. However, bears' analyses seem to center on worst-case scenarios rather than addressing the full range of possibilities for the conglomerate.
GE bears are underestimating the company's turnaround potential. Image source: General Electric.
For example, a few months ago, GE stock fell after Inch raised concerns that Danaher might try to back out of its agreement to buy GE's biopharma unit for about $21 billion. He claimed that bad quarterly reports from other life sciences companies might force GE to reduce the sale price to ensure the deal's completion. Had that been true, it would have been a serious concern, as the biopharma deal is critical to GE's debt reduction plan.
However, there was never any firm evidence to support these concerns. Sure enough, Danaher said last month that the GE biopharma deal is still on track to close by the end of 2019. Between that deal and the sale of its remaining interests in Wabtec and Baker Hughes, a GE Company, General Electric will raise about $35 billion (before tax) that it can use to pay down debt. The company also plans to sell $10 billion of assets from its GE Capital subsidiary this year.
Meanwhile, it was never a secret that GE's cash flow would be weak in 2019. Between losses on legacy contracts, one-time legal settlements, and restructuring costs, the company entered the year expecting to burn billions of dollars of cash in its power and renewable-energy segments. All of those headwinds are set to fade over the next two years, putting those struggling units on the path to return to positive cash flow. If anything, the recent increase to GE's guidance for free cash flow should give investors more confidence in an eventual cash-flow recovery.
The next few months will be crucial
While GE's performance is finally stabilizing after a couple of awful years, there are two noteworthy risks that could derail its turnaround, aside from plain-old bad execution. First, its long-term care insurance liabilities could rise further if the volume and severity of claims exceed the company's assumptions.
Second, the Boeing 737 MAX grounding is weighing on cash flow by delaying deliveries and payments for LEAP engines made by CFM, GE Aviation's joint venture with Safran. And the longer the grounding drags on, the bigger the potential damage to the 737 MAX's sales prospects. That would reduce the future profit stream from building and maintaining LEAP engines.
Investors will learn a lot more about the severity of these risks over the next few months. GE is scheduled to complete the annual testing of its insurance portfolio for potential problems this quarter. In addition, Boeing expects to submit a final software fix to address the 737 MAX's flaws by the end of September, enabling the plane to return to service later this year.
If the insurance testing turns up new problems or the 737 MAX suffers another major setback, GE stock could continue to fall. But if not, then the company's balance sheet improvements, the turnarounds in the power and renewables segments, and the secular growth of GE Aviation could drive strong gains for GE stock over the next year or two.
