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Why GE's Long-Term Future Still Looks Bright

By Lee Samaha – Aug 6, 2021 at 7:55AM

Key Points

  • It's been a long time coming, but the turnaround at GE Power is showing real progress.
  • GE's faces a couple of potential near-term problems, but they look temporary in nature.
  • The company remains on track for a substantial increase in earnings and cash flow in the coming years.

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Analyzing the near-term and long-term earnings drivers.

The fact that GE Power was the star segment in General Electric's (GE 0.31%) second quarter is meaningful. It speaks volumes for CEO Larry Culp's impact on the company since Oct. 2018. The segment's performance was the high spot in a quarter that contained a lot of good news and some blemishes that need to be monitored. Still, GE remains on the right track. Here's the lowdown.

Free cash flow guidance

By now, most investors, and certainly GE's management, know that the market keys off of GE's free cash flow (FCF) performance. The good news is investors got what they wanted. FCF came in at $383 million in the quarter, when management's last public statements had suggested there would be a $400 million outflow.

The better-than-expected performance led management to increase its full-year industrial FCF guidance to a range of $3.5 billion to $5 billion, compared to previous guidance for between $2.5 billion and $4.5 billion. It represents an increase of $750 million at the midpoint, which tallies with the FCF "beat" in the second quarter.

Cash flow.

Image source: Getty Images.

Still, investors shouldn't be too quick to conclude that everything is hunky-dory; there were a couple of negatives in the quarter, notably in the aviation and renewable energy segments. Meanwhile, power and healthcare delivered the bright spots.

GE Aviation

During GE's investor outlook meeting in March, management gave full-year 2021 guidance for GE Aviation revenue to rise by a low-single-digit percentage with margin in the low-double-digit range. While management is sticking to the margin guidance, CFO Carolina Dybeck Happe said she now expects full-year revenue to be flat in 2020.

The reason? She put it down to two things: one, a $400 million noncash contract margin review (CMR), of which two-thirds "was related to one contract in a loss position," and two, "internal and external supply chain issues" plagued GE Aviation's military business.

Interestingly, Honeywell also lowered its full-year aerospace segment revenue guidance on the back of "moderating U.S. defense" spending and "slower-than-expected international defense volumes," according to Honeywell CFO Greg Lewis on the earnings call. It's not clear whether Honeywell and GE's military business problems stem from the same source, but the weakness is worth monitoring at both companies.

As for the CMR, Dybeck Happe said GE Aviation had around 200 contractual service agreements (CSA), and "only a couple" are loss-making. However, the $400 million charges taken on one of them in the quarter indicate the ongoing stress in the aviation sector.

On the whole, the aviation segment remains in recovery mode. However, as you can see in the chart of GE Aviation's spares rate (my favorite lead indicator for GE Aviation), there's a long runway of growth ahead until GE gets back to 2019 levels.

General Electric Aviation spares rate chart.

Data source: General Electric presentations. Chart by author.

GE Renewable Energy

Dybeck Happe didn't adjust guidance for the segment, so investors can continue to expect mid-single-digit revenue growth, margin improvement, and FCF generation in 2021. On the other hand, she noted that a "long-term extension" of production tax credits (PTC) would create some near-term uncertainty as it "pushes out investment decisions for what could be years." In other words, customers might not rush to place orders if they know the PTC will be extended.

While it's not an problem for the industrial company in the long-term, it's a positive, and a PTC extension could affect GE's "second half orders profile and positive free cash flow outlook for the year," according to Dybeck Happe.

Wind turbines.

Image source: Getty Images.

GE Healthcare

Management now expects segment profit margin to expand from 15.8% in 2020 to more than 16.8% in 2021. This is compared to a previous range of around 16% to 16.5%. In addition, GE Healthcare is likely to see a good second half with the economy reopening and non-COVID-19-related healthcare procedures coming back.

GE Power

As Culp noted, "This is never going to be a high-growth business for us," but that doesn't mean it can't be a valuable FCF generator for the company. Indeed, Culp expects GE Power to deliver $1 billion to $2 billion in FCF by 2023 -- figures that would mark a dramatic improvement over the minimal FCF generated in 2020.

According to Culp, the good news here is that gas power services are likely to "do better than that low single-digit revenue'' guidance. Meanwhile, Dybeck Happe confirmed that GE Power was on track to hit its target of high-single-digit margin over time.

A gas turbine.

Image source: Getty Images.

Indeed, in a sign that GE Gas Power is improving the execution of its services, the CEO of gas power, Scott Strazik, was promoted to CEO of GE Power overall. Also, GE Power's overall margin came in at 7% in the quarter -- a good sign.

What it means to investors

The potential problems around aviation and renewable energy look to be temporary. So, while travel restrictions could hurt GE Aviation, and GE Renewable Energy could get hit with a PTC extension, they are both likely to be near-term problems at worst. Moreover, both are businesses with good long-term growth prospects.

Meanwhile, GE Healthcare is in good shape, and GE Power looks to be well on track to become a handy cash generator rather than a drag. For the long-term investor, the potential near-term turbulence in 2021 can be overlooked in favor of the positive underlying development of the business. As such GE's stock price stands well placed to improve.

Lee Samaha owns shares of Honeywell International. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.

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