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Morningstar | Weakness at Power Still Vexes Narrow-Moat General Electric During 2Q

Narrow-moat General Electric reported results that were broadly in line with our expectations. We don’t plan on materially altering our $15.70 fair value estimate, although we may moderate our expectations for the renewable energy segment, offset by greater-than-anticipated strength in oil and gas. Even so, these are smaller components of GE’s profitability, with the stock’s present form primarily driven by performance in aviation, healthcare, and power, as well as any unexpected losses in GE Capital. Healthcare continues to move toward separation, and we think the power business still faces long-term headwinds. Finally, management lowered industrial free cash flow guidance to the bottom of its previously announced range for 2018 (to $6 billion from $6 billion to $7 billion previously).

Aviation is the most significant needle mover from a profitability standpoint, and revenue rose 13% year over year to about $7.5 billion. Although CFM, the 50/50 joint venture between General Electric and Safran was previously seven weeks behind in LEAP engine deliveries (the successor to the CFM56), CFM representatives affirmed that the JV had chopped this delay to around four weeks. More importantly, CFM is confident that it will meet its target to deliver 1,100 LEAP engines by the end of this year. Because LEAP engines are sold at a loss, delivery delays will likely translate to higher profitability for GE during the front half of the year relative to the back half. Increased LEAP deliveries this quarter account for the 110-basis-point decrease year over year for a segment profit margin of 19.6%.

One thing we are hearing is that CFM is wrestling with whether to develop a new engine for the Boeing 797. Even with generous assumptions, our prior assessment is that this project faces limited market demand, and unless something changes, we think it’s unlikely that CFM would undertake such an endeavor and even more unlikely that GE would go it alone on the program.

We’re also not surprised by weakness at power, the firm’s largest segment by revenue. GE reports that first-half trends continue to indicate a gas power market of less than 30 gigawatts in 2018. Power’s revenue is trending below our expectations at $14.8 billion, but we anticipated segment profit margin headwinds, which year over year amount to 500 basis points. As such, segment profits of $694 million for the first half of the year are in line with our expectations for full-year 2018. GE announced that it will focus on aviation, power, and renewable energy, with planned separations of healthcare and oil and gas. With continued and increasing dependence on a beleaguered power business (which will become a greater proportion of the remaining business), we continue to believe that it will not be the quick fix the market has immediately praised, as evidenced by the stock price's reaction to management's announced portfolio changes. Our initial sense is that management sees a brighter future for natural gas than we do. Over the long term, we think renewables will continue to pose a secular threat from a normalized cost of energy standpoint, and that the fossil fuel market will continue to face pricing pressure.

Healthcare, which we see as GE’s second-best business, is also performing according to our expectations. Segment revenue is up 6% year over year to nearly $5 billion, helped by life sciences. In our view, the firm is losing one of its moatier assets to raise cash and satisfy the credit ratings agencies and move toward a net debt/EBITDA target of 2.5 times. Bottom line, we think this is an equity raise but through shedding an attractive asset.

Finally, we were disappointed that GE didn’t provide any material updates, in our view, to GE Capital. The overhang of WMC (residential mortgages) still lingers and predicting the timing and impact of this legacy entity is notably hard to forecast. Capital’s continuing operations posted a $207 million loss this quarter. However, for the front half of the year, and including discontinued operations, GE Capital has posted about a $2 billion loss. While management continues to pare down GE Capital assets (selling $2 billion of assets in the second quarter), we suspect that future sales of more troublesome legacy assets will require some promise on the part of GE to backstop these liabilities.