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Morningstar | The Day Will Come When We No Longer See GE Bears’ Shadows Around Groundhog Day

Narrow-moat rated General Electric reported fourth-quarter results that blew well past our revenue assumptions for the year. However, GE fell slightly short of our below-consensus adjusted EPS estimates and more importantly, exceeded our GAAP EPS expectations. The firm’s top-line growth strength was broad-based and exceeded our full-year expectations across all seven of GE’s industrial segments; we expected industrial revenue of $118.4 billion versus $121.6 billion of actual results. While we generally don't project quarterly adjusted EPS, our most recent full-year 2018 adjusted EPS expectations implied 19 cents per share against 17 cents per share of actual results (versus 22 cents per share for consensus estimates). The adjusted industrial free cash flow generation of positive $4.5 billion was the most important item this quarter. Free cash flow swung positive thanks to both positive earnings as well as better payables performance throughout the year and inventory liquidations.

While we evaluate the various puts and takes in our model (including some additional short-term GE Power headwinds offset by positive developments on the GE Capital liabilities front), we don’t anticipate materially changing our fair value estimate of $13.80, which we maintain for now prior to our annual model roll. We also maintain our narrow moat, stable trend, very high uncertainty, and poor stewardship ratings. Although the call was admittedly light on details toward the future and lacked the guidance analysts wanted to hear, we view the firm’s results, as well as its free cash flow generation, as a welcomed net positive and a leading indicator that the future is brighter than GE’s recent past. While the stock has rallied about 50% since it last tripped 5-stars on Christmas Eve, we continue to demand a wide margin of safety around the name.

Disciplined investors should know that the risk for investing in GE has now actually risen because the discount to our intrinsic value has now diminished to 24%. For reference, our 5-star price hovers just below $7 per share. Nonetheless, we believe shares continue to trade below our combined stand-alone value of GE Aviation and GE Healthcare (about $11 per share), even after incorporating all the firm’s total calculated liabilities. As a reminder, investors still get liquid assets like GE's 50.4% interest in BHGE, which trades in the public market, essentially “for free.” Finally, for reference, CEO Larry Culp bought 225,000 GE shares at a price of $9.73 back in November.

The most important items on the call came around additional details of the firm’s liabilities, as we think investors should continue to focus their attention on downside risks. The two most important positive items, in our view, are related to GE Capital. First and foremost, the FIRREA penalty obligation came in well below our expectations and right in line with GE’s reserve of $1.5 billion. We originally expected that the total projected FIRREA obligation would total over $4 billion based on a comparable penalty Bank of America paid in 2014 for its Countrywide portfolio. Additionally, for now, the annual insurance test conducted in the fourth quarter revealed only a relatively minor $65 million after-tax charge compared with some of the inflated estimates from the Street. More importantly, GE announced that it will be inserting increasing disclosures on the insurance front in line with peers.

We expect that the relatively small insurance reserve reassessment this year was helped by rising interest rates, which probably generated a tailwind via higher interest income. That said, we believe long-term claim experience is likely to continue rising, which should largely offset increasing interest income. We detail this view in our piece titled, “In Culp We Trust: How Larry Legend Will Close the Price-Value Gap in the Clutch.” We are leaving our current reserve shortfall on the insurance front just shy of $4 billion intact for GE Capital out of an abundance of conservativism. Interestingly, the firm contributed $4 billion this year to GE Capital’s reserves, slightly ahead of our expectations of $3.5 billion, but nevertheless greater than what management previously anticipated. Bottom line, we think bears are off on their negative $3 per share calculation for GE Capital; we model Capital worth $.49 per share.

GE Power continues to be a sore spot, particularly amid ongoing secular and cyclical pressures as well as the warranty and other impacts related to oxidation issues GE disclosed back in October last year. GE already announced extensive restructurings in Power, which we expect to hear more about over the coming months, as Culp solidifies his longer-term strategic planning. We think the split should give GE additional visibility into the unit given its very disparate businesses. We like the moves Culp has made combining the grid business with the renewables business, and we continue to believe the steam portion of the portfolio remains less attractive relative to other assets. We’d like to eventually see GE sell the steam assets, and we think separating these two platforms potentially offers the company a chance to do so. We still believe the Power turnaround story will last for a minimum of two (and possibly up to four) years. On the positive side of the ledger, Culp reported that headcount is down by 15% and footprint consolidation is down by 30% from prior-year levels.

Aviation once again had a standout quarter, even as the LEAP engine is still four weeks behind on its delivery schedule. Of course, this positively impacts profitability as the engine is still in ramp. Jamie Miller gave some color on the call regarding when the LEAP engine program will break even. She pointed to 2021, which aligns with our forecasts. Miller, however, stressed that margin drag from the LEAP was being offset by growth in higher-margin aftermarket service revenue as well as other factors.

As for GE Healthcare, Culp confirmed that the plan to sell some of the unit remains intact, despite analyst concerns that GE will lose one of its highest cash-generating units. Interestingly, the plan now seems to sell just under 50% of Healthcare while still preserving the tax-free nature of the transaction. Management estimates of cash from potential asset sales are just shy of $50 billion and are in line with our back of the envelope math of about $46 billion plus (which excludes the previously rumored and now debunked GECAS sale as well as any industrial free cash flow). We agree with management’s analysis of looking at both GE Capital’s debt (which GE is on the hook for) and GE industrial’s debt separately, which we also do in our own analysis. We also appreciate that the firm has listened to the analyst community and has improved its disclosure around net debt calculations.

Bears will inevitably interpret Culp’s reticence to provide any guidance as a continuation of GE’s previous practice of evading hard questions. We disagree with this viewpoint. We think it's far worse for Culp to provide overly inflated numbers in the mold of Immelt and Flannery and fall well short of his projections. We prefer Culp comes up with realistic numbers that are achievable and that the firm consistently hit its targets. We are also pleased that corporate reductions are in full swing, with corporate items and eliminations down 31% over the previous year. While near-term free cash flow strength certainly bakes in some short-term benefits (like extending payables and inventory liquidations), we reiterate our view that GE’s assets are worth more than the market price and that CEO Larry Culp will successfully lead a multi-year turnaround for the firm.