There's no doubt that better free-cash-flow (FCF) guidance was the catalyst for the startling jump in General Electric's (GE +6.68%) share price after its third-quarter earnings. The good news is, for the second quarter in a row, CEO Larry Culp raised that guidance and gave investors hope that better days are ahead.
Let's take a look at what happened and why it matters.
General Electric's guidance
FCF is key to shareholders because it represents the cash the company can use to pay down debt, pay dividends, or initiate share buybacks. It's basically the cash that's left from earnings after working capital requirements (the cash used to run the business) and capital expenditures are taken out.
Image source: Getty Images.
The table below shows the blue chip stock's overall guidance changes this year. GE has increased the midpoint of its FCF guidance by $2 billion from March to now, and by $1 billion since the last earnings report. GE has reported no change to the revenue, margin, or earnings outlook since the last quarter, though.
Granted, there may have been a shift in earnings expectations toward the upper end of the $0.55 to $0.65 range, but given that guidance remains the same, it's safe to assume the hike in FCF guidance isn't coming from better earnings expectations. So, where's it coming from?
| General Electric |
As of 3rd-Quarter Earnings in October |
As of 2nd-Quarter Earnings in July |
Investor Outlook in March |
|---|---|---|---|
|
Revenue growth |
Mid single-digits |
Mid single-digits |
Low to mid single-digits |
|
Margin growth |
0 to 100 bps |
0 to 100 bps |
0 to 100 bps |
|
EPS |
$0.55-$0.65 |
$0.55-$0.65 |
$0.50-$0.60 |
|
Industrial free cash flow |
$0 to $2 billion |
$(1) billion to $1 billion |
$(2) billion to $0 |
Data source: Company presentations.
General Electric's free-cash-flow guidance
The improvement in FCF guidance is almost entirely down to the power segment -- management didn't adjust headline FCF guidance for any other segment. However, there are some underlying improvements at aviation -- I'll return to this point later. Also, it's worth noting that GE's guidance is quite vague, so for example, "no change" to aviation and healthcare guidance of "flat" and "down," respectively, doesn't mean there couldn't have been an improvement of, say, $100 million here or there from those segments.
That said, GE highlighted the following factors as being responsible for the increase in FCF guidance at the midpoint of $1 billion from the second quarter to the third:
- "Supply chain finance transition going well"
- "Aviation timing & services"
- "Lower restructuring"
- "Healthcare strong"
There are three positive takeaways from these bullet points and one negative.
The bad news
As you can see below, GE's healthcare orders growth continues to be patchy, but more concerning is the fact that the strength is coming from the biopharma business GE is selling to Danaher (DHR +0.17%) rather than the remaining healthcare systems businesses.
In fact, within healthcare, life sciences (which includes biopharma and pharmaceutical diagnostics) organic orders were up 10%, and reported life sciences revenue in the quarter was up 12%. This compares favorably with healthcare systems organic orders, which were flat in the quarter while healthcare systems reported revenue was up 2%.
In other words, the strength in GE's healthcare business appears to be coming from a business (biopharma) GE is selling.
Data source: Company presentations.
Three big positives on cash flow
That said, it would be unfair to ignore the positives from the report. GE's filing to the SEC contained a reference to a belief that the power business "is showing early signs of stabilization" and builds on the relatively positive outlook given by Larry Culp at a recent investment conference.
Due to the improvement at power, GE lowered its expectation for cash restructuring costs in 2019 to $1.3 billion from $1.5 billion previously -- accounting for $200 million of the $1 billion improvement in the FCF outlook.
"Supply chain finance transition" simply means GE is reducing its working capital requirements by bringing forward cash payments, often via discounting, in order to improve cash flow -- a sign of how Larry Culp is transforming the company to be more cash generative.
The third positive is that a strong commercial aviation market -- seen by both Honeywell and United Technologies in the current earnings season -- has increased high margin and cash flow generative aftermarket sales. For example, the commercial spares unit rate improved in the quarter on a sequential and year-over-year basis. In other words, GE is selling more spare engine parts as airlines make more flights in line with buoyant passenger demand.
Moreover, management cited better than expected aviation allowance and discount payments, which helped offset a $1 billion cash headwind it was experiencing because of its inability to receive cash for LEAP engines for the grounded Boeing 737 MAX.
Data source: Company presentations.
The takeaway
The healthcare segment's results will be a concern to GE investors, but a boon to Danaher's. Meanwhile, the power segment's gradual (if slow) improvement is a positive as are Culp's efforts to improve working capital requirements. Meanwhile, if the Boeing 737 MAX can return to service, GE could see some upside to cash-flow expectations in the future as engines will be shipped again leading to cash payments to GE. In addition, a buoyant aviation market has definitely improved underlying cash generation at GE Aviation this year.
All told, Larry Culp continues to engineer a turnaround at GE, and while operational progress on earnings is still a bit slow, cash flow generation is improving and investors can feel confident the company is on the right track.
