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GE's Turnaround Just Took a Huge Step Forward

By Adam Levine-Weinberg – Oct 30, 2020 at 7:20AM

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The industrial conglomerate bounced back from a rough first half of 2020, despite continuing headwinds from the COVID-19 pandemic.

Investors have dumped General Electric (GE 1.69%) stock in 2020, fearing that the COVID-19 pandemic would severely damage the conglomerate's turnaround prospects. GE's second-quarter results provided some basis for that pessimism. Organic revenue for its industrial businesses plunged 20%, the company posted an adjusted net loss of $0.15 per share, and industrial free cash flow was -$2.1 billion.

Fortunately, GE's results improved significantly in the third quarter, despite ongoing pressure from the pandemic. Management expects further progress in the fourth quarter and beyond, paving the way for a sharp rebound in GE stock, which is still down more than 30% year to date.

GE Chart

GE stock year-to-date performance. Data by YCharts.

Strong sequential improvement

On Wednesday, General Electric reported that industrial organic revenue declined 12% to $17.9 billion last quarter. This represented a big sequential improvement over the second quarter. In fact, revenue increased organically on a year-over-year basis in three of GE's four industrial segments. The exception was GE Aviation, which has been hit hard this year along with the broader aviation industry. The unit's 39% organic revenue decline more than offset the growth in GE's other divisions.

GE's better-than-expected revenue performance and its swift cost-cutting actions earlier this year helped the company deliver operating profits in all four industrial segments for the first time in two years. (That said, its renewable energy segment earned just $5 million last quarter).

On a company-wide basis, GE posted an adjusted industrial operating margin of 5.6%, compared to 10% a year earlier. Adjusted industrial profit fell 53% year over year to $1 billion. Meanwhile, adjusted earnings per share fell 60% to $0.06. Still, getting back to positive territory for these metrics was an impressive accomplishment after big losses a quarter earlier. On average, analysts had expected a Q3 loss of $0.04 per share.

Finally, GE's industrial free cash flow turned positive at $514 million. This was down from $650 million a year ago but up year over year, excluding the impact of selling the company's biopharma unit earlier this year.

A GE jet engine in a test cell.

Image source: General Electric.

No surprises

Coming into the quarterly report, analysts wondered whether there would be any ugly surprises. GE completed annual evaluations of its GECAS aircraft leasing unit and its runoff insurance business during the third quarter. The company also disclosed earlier this month that it had received a Wells notice warning of potential Securities and Exchange Commission enforcement action related to its accounting practices.

There was nothing to fear, though. GECAS recorded a modest $163 million impairment charge due to the decline in aircraft values and elevated bankruptcy filings in the airline industry. That brought its total impairments for the year to around $500 million, out of a total portfolio of leased equipment worth about $29 billion. GE also booked a $100 million reserve to cover any costs related to the SEC investigations.

The biggest risk came from the insurance review. However, GE's analysis found that claims experience has been a little better than expected recently and that future long-term care premium increases are likely to be higher than previously assumed. These positive factors more than offset a headwind from lower interest rates. The results of this review didn't impact earnings, but the net benefit of $393 million gives GE a small margin of safety against future adverse claims experience.

The turnaround is on track

Looking ahead to the fourth quarter, General Electric expects further sequential improvement in revenue, earnings, and cash flow. This reflects a combination of normal seasonality (Q4 is generally the strongest part of the year for GE), growing traction from cost-cutting efforts, and a shift in the timing of certain projects from earlier in the year due to the pandemic.

In fact, management said that industrial free cash flow will likely total at least $2.5 billion this quarter. Under current CEO Larry Culp, GE has generally provided conservative guidance, so this target is probably beatable. Indeed, the company generated industrial free cash flow of $3.9 billion in the fourth quarter of 2019.

GE is well positioned to capitalize on additional savings in its power and renewable energy units over the next two years as the conglomerate makes progress on multiyear turnaround plans in those divisions. As coronavirus vaccines become widely available and aviation activity starts to return to normal levels, free cash flow should rebound rapidly in the aviation segment. This brightening outlook makes GE stock look very attractive at its current marked-down price.

Adam Levine-Weinberg owns shares of General Electric. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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