There are two key takeaways from General Electric's (GE 1.49%) latest earnings report. First, its industrial free cash flow (FCF) generation is going to be better in 2020 than most watchers had feared. Second, there are real signs of operational improvements at the company. Both points are critical to the long-term investment case for the stock.
General Electric's free cash flow
The company's FCF of $514 million in the third quarter was pretty good in the context of a 39% drop in revenue from its key aviation segment. As a reminder, GE is heavily reliant on GE Aviation for FCF. Indeed, the segment generated $4.4 billion in FCF in 2019, compared to $2.5 billion from GE Healthcare, and outflows of $1 billion and $1.5 billion from GE Renewable Energy and GE Power, respectively.
General Electric is improving its free cash flow. Image source: Getty Images.
Not only was the third quarter better than expected, but management guided toward FCF of at least $2.5 billion in the fourth quarter. Given that GE had an outflow of $3.76 billion in the first nine months of the year, that implies an outflow of $1.26 billion for 2020. While that's not a great figure in itself, it would be substantially better than the outflow of $3 billion to $4 billion that Wall Street analysts had penciled in for 2020 earlier in the year.
Operational improvements
The near-term cash flow guidance is good news, but the really salient points for investors to consider here are the operational improvements that management has made in the business, and particularly in the non-aviation businesses.
The table below highlights the fact that margin improved significantly in the power, healthcare, and renewable energy segments. Obviously, the market will hone in on the aviation segment's weakness, but there's little that GE management can do about the state of the commercial aviation market right now, so it makes more sense to focus on what management can do.
In addition, the investment case for GE stock isn't just about buying into a play on a recovery in air travel. There's also a significant opportunity for GE to grow its profits by expanding its margins in the power and renewable energy segments. Both segments' margins lag those of their respective key competitors, and CEO Larry Culp is determined to close those gaps.
The good news from the third quarter is that both of those segments returned to profitability. It's not inconceivable that, given a return to the kind of mid-to-high-single-digit percentage margins of their peers, they could be generating $1 billion apiece in FCF in a few years time.
| GE Segment |
Profit Q3 2020 |
Organic Revenue Growth Q3 2020 |
Profit Margin Q3 2020 |
Profit Margin Q3 2019 |
|---|---|---|---|---|
|
Power |
$150 million |
3% |
3.7% |
(3.7%) |
|
Renewable Energy |
$5 million |
4% |
0.1% |
(2.2%) |
|
Aviation |
$356 million |
(39%) |
7.2% |
21.2% |
|
Healthcare |
$765 million |
10%* |
16.8% |
14.2%** |
Data source: General Electric presentations. *up 3% excluding ventilator deliveries to the U.S. government. **Comparable profit margin excluding the now-divested biopharma business.
Renewable energy and power
On the GE earnings call, CFO Carolina Dybeck Happe credited the margin expansion in renewable energy to "cost productivity, better pricing, and volume in onshore wind North America." She also highlighted the fact that "onshore wind delivery is near record volume." Her reference to improved pricing is a sign that the company's focus on securing profitable deals rather than simply chasing volume is bearing fruit. Furthermore, GE is starting to sign contracts for its entry into the offshore wind market with its giant Haliade-X turbine.
The worldwide shift toward generating more from electricity wind and solar installations is good news for GE Renewable Energy, and it will give that business unit growth opportunities, so investors can think of it as both a margin expansion and a growth story.
Image source: Getty Images.
However, the shift toward renewable energy also implies that sales growth for GE's gas turbine business will slow down. As such, the outlook isn't so rosy for GE Power, with Culp suggesting that the end market for heavy-duty gas turbines will shrink to 25 gigawatts to 30 gigawatts annually in the future. For reference, it was closer to 60 gigawatts in 2015.
That said, there's still an opportunity to improve the equipment and services margin, and the evidence is that the industrial company is starting to do that. Management cited better project execution and cost productivity in power, and just as with renewable energy, GE Power has an opportunity to improve its margins and get back to generating significant cash flow again.
Looking ahead
GE is still a stock to be avoided by those worried about the long-term future of the airline industry. However, the improving trends in power and renewable energy mean potential investors can start to price in some FCF contributions from those businesses in a few years.
Combine those contributions with a recovery in aviation and ongoing solid performance from the healthcare unit, and GE could be generating significant amounts of FCF in a few years. That could make this stock a strong value for investors who are willing to be patient. The good news is that the investment case was strengthened by the recent quarterly results.
