By now, most General Electric (NYSE:GE) investors will know that CEO Larry Culp gave a presentation and allayed fears that GE would report a cash outflow in the second half of this year. And that was enough to send the share price surging and generate a double-digit return on the stock in just a couple of days. What does that say about the stock, and what exactly did Culp say to justify such a move? Let's take a closer look.
Three takeaways from the presentation
Digging into the details of the presentation at the Morgan Stanley Laguna Conference, there are three things for investors to consider:
- Culp has a track record of being conservative on guidance, and then delivering figures significantly ahead of his previous outlook.
- GE's second half, and in particular the fourth quarter, is traditionally where the company generates most of its free cash flow (FCF).
- The move upwards highlights the favorable risk/reward profile the stock carries, and the potential upside if Culp delivers on his plans.
Underpromise and overdeliver
Ever since Culp took over as CEO in October 2018, he's been cautious in his guidance -- and when he's given it, he appears to have deliberately set the bar low. A case in point comes from the industrial FCF guidance given in 2019. GE started 2019 guiding toward breakeven to outflow of cash of up to $2 billion, only to end up with FCF of $2.3 billion. The 2019 figure represents a difference of $3.3 billion from the midpoint of original guidance.
Turning to 2020, GE started 2020 with Culp guiding for $2 billion to $4 billion in FCF. Again, it's a very wide range, and indicative of a conservative approach to guidance.
Of course, the COVID-19 pandemic challenged GE's prospects in 2020, and expectations have had to be lowered. As such, GE's management fell short of affirming that FCF would be positive in the second half during the second-quarter earnings call. Culp's recent affirmation served to allay investors' fears.
General Electric always generates free cash flow in the second half
In the context of the slump in the economy in 2020 and GE's ongoing cash flow generation issues, Culp's update has to be taken as a net positive, but investors shouldn't get too excited.
The fact is that GE's cash flows have always been highly seasonal, and in particular heavily weighted toward the fourth quarter. The chart below shows how GE's FCF during the fourth quarter of the last three years has more than offset outflows in the first three quarters. As such, positive FCF in the second half, although obviously welcome, should not be seen as a game-changer for the industrial company. Indeed, the cash outflow was $4.3 billion in the first half, and analysts are still expecting $3 billion to $4 billion outflow for the full year.
A skeptical take
Looking at matters skeptically, it's easy to conclude that GE's stock is merely benefiting from a short-term bump because Culp has deliberately lowballed FCF expectations, only to later hurdle them easily. Moreover, positive FCF generation in the second half is really nothing new, as GE always goes cash collecting in the fourth quarter anyway.
In addition, the aviation segment (GE's main cash generator) remains under severe pressure, and the headline news on the COVID-19 pandemic has not been positive recently. For example, the International Air Transport Association recently described the improvement in passenger demand as "sluggish."
A favorable risk/reward profile
All of the above may well be true, and GE investors should brace themselves for some potential near-term disappointment from GE Aviation in the coming quarters. However, it's also worth noting that the sharp uptick in the stock price after Culp's comments is also an indication of the favorable risk/reward profile of the stock.
The case for buying GE stock accepts that it's going to be a rocky road to recovery in aviation, but there'll be a recovery nonetheless. Meanwhile, the healthcare segment is set to generate $1 billion-plus in FCF per year for the foreseeable future, and Culp has realistic plans to turn around the power and renewable energy segments so they can generate FCF again in a few years.
It all adds up to GE having the potential to generate $5 billion to $7 billion in annual FCF within the next five years. Given that the market cap is only $61 billion, those kind of figures would make GE look like a very good long-term value. However, be aware that the near-term risk for disappointment with aviation is significant.