General Electric (GE +2.28%) is a far from perfect company, but it's good enough to warrant a serious look by value-orientated investors looking for a stock that's been left behind by the market. GE's recent earnings report showed just how badly the company has been hit by the COVID-19 pandemic, but it looks likely that the second quarter of 2020 will mark a multi-year low point, and all of its segments should improve from here. Let's take a closer look at why GE is an interesting stock to buy.
The investment thesis
The case for GE being a good value is based on the following points:
- CEO Larry Culp appears to have returned to giving very conservative guidance in order to make it easier to underpromise and overdeliver -- usually a favorable outcome for investors.
- GE is taking action to reduce costs by $2 billion and cash actions of $3 billion in order to improve profits and free cash flow (FCF) with expected annual structural cost reduction of $1.5 billion to $2 billion.
- The company has been badly hit in 2020, but all of its segments should improve from the second quarter.
- A combination of underlying cash flow generation potential and turnarounds in progress in power and renewable energy should lead to substantially more cash flow in the future.
GE needs air traffic to recover. Image source: Getty Images.
Underpromise and overdeliver
Back at the end of May, Culp told investors that the cash outflow would be some $3.5 billion to $4.5 billion in the second quarter, but the figure came in a lot better, with an industrial free-cash outflow of just $2.1 billion. For reference, industrial FCF is simply that generated by its industrial businesses, and therefore strips out GE Capital -- finance companies are not best valued using FCF.
If this kind of underpromising and overdelivering sounds familiar, it comes from the fact that Culp started 2019 predicting an industrial free-cash outflow of up to $2 billion only to end the year with $2.3 billion in FCF.
While Culp didn't give guidance for 2020 during the last earnings call, he did say that FCF would turn positive in 2021. Given recent history, it's reasonable to expect good FCF next year.
Cost actions
Given the carnage wrought on the industrial economy by the coronavirus pandemic, it's no surprise to see industrial conglomerates trying to reduce costs and preserve cash. However, the key question is how much of these actions are temporary (only to be pulled back as end demand improves) and how many are structural?
"[W]hat we can say is that one-third to one-half of those $2 billion are structural cost out," CFO Carolina Dybeck Happe said in response to that question on the earnings call. "And that actually annualizes to $1.5 to $2 billion." Clearly, GE has levers it can pull to improve near-term FCF and also reduce cost.
Earnings will get better
A look at GE's industrial segments in the second quarter (table below) shows the extent of the damage done, with only the healthcare segment reporting a profit. However, there's reason to believe that all four industrial segments will improve over the near and long terms.
Excluding the now divested biopharma business, GE's healthcare orders were only down 1% organically, and as elective procedures and other non-COVID-19 related activities come back, profitability in GE's healthcare segment should improve.
Power was also negatively impacted by COVID-19, particularly in its higher-margin services business. Looking ahead, Dybeck Happe believes "our current pipeline suggests improved equipment orders, while we expect service orders to remain challenged." That suggests margins could be constrained for some time in power. Nonetheless, service revenue should improve as service outages have been shifted to the second half due to the COVID-19 pandemic.
In renewable energy, Dybeck Happe said orders had been pushed into the second half "due to financing and permitting delays related to COVID-19." In addition, she outlined that onshore wind had better "price, product cost and mix, improved project execution and accelerated cost out." In other words, GE's underlying attempts to improve margins in the renewables segment are starting to work.
Image source: Getty Images.
Finally, it goes without saying that GE Aviation's prospects will be guided by conditions in commercial aerospace. That, in turn, is dependent on the containment of the virus.
Most commentators expect that commercial air traffic won't get back to 2019 levels until 2023, so don't expect a sharp recovery any time soon. However, GE Aviation generated around $4.4 billion in FCF in 2019, and that's a useful target to aim for in the next few years.
|
GE Industrial Segments in Q2 |
Orders (in Millions) |
Change (YOY) |
Revenue (in Millions) |
Change (YOY) |
Profit (in Millions) |
Segment Margin |
Change |
|---|---|---|---|---|---|---|---|
|
Power |
$2,872 |
(42%) |
$4,156 |
(11%) |
($40) |
(1%) |
(350) bps |
|
Renewable Energy |
$2,987 |
(19%) |
$3,505 |
(3)% |
($195) |
(5.6%) |
(50) bps |
|
Aviation |
$3,739 |
(56%) |
$4,384 |
(44%) |
($680) |
(15.5%) |
(3,310) bps |
|
Healthcare |
$4,246 |
(18%) |
$3,893 |
(21%) |
$550 |
14.1% |
(530) bps |
Data source: General Electric presentations. YOY = year-over-year. BPS = basis points where 100 bps = 1%.
Is General Electric a buy?
With the power and renewable energy businesses in turnaround mode, and healthcare continuing to generate solid FCF, the stock looks to be a good value provided the aviation segment makes a slow recovery.
At a price of $6.30, GE has a market cap of just $55.2 billion, and it's not hard to see that GE could be a generating a few billion dollars in FCF by 2022. In fact, analysts have the company producing $4 billion in FCF in 2022, and if GE hits this target then it will its current market cap would mean it trades on just 13 times its 2022 FCF -- a very good value.
All told, if you can tolerate the volatility inherent in owning a stock heavily exposed to commercial aviation, then GE is stock worth buying for the long-term investors right now.
