GE's Stock Price Largely Reflects Our Positive Outlook

We have greater confidence in General Electric’s GE path to recovery, and the company’s deleveraging efforts have progressed further than we initially expected. However, the bear case continues to cast doubt over the industrial conglomerate’s future. We think GE has appreciable value that bears fail to acknowledge.

• We've concluded that GE Aviation is worth far more than bears give it credit for, mostly because we believe they underestimate the contribution from narrow-body aftermarket sales.
• GE Healthcare has outperformed analyst expectations during the pandemic, and we think its expertise in the diagnostic imaging markets positions it to address some of the industry's most pressing challenges and promote continued growth and margin expansion even after the sale of GE Biopharma.
• GE has multiple levers that it can pull, which gives us confidence that the company has a viable path to its long-term target of high-single-digit free cash flow margin.

The significant mispricing opportunity for GE shares is over, although we think there’s still minor upside. We do caution investors that our fair value estimate is a long-term stock call.

Bears Underestimate the Value of GE Aviation

It’s true that we think GE’s recovery is more difficult because of its commercial aerospace headwinds. We don’t expect that market to recover to 2019 levels until sometime in 2024. The global pandemic has impaired the value we once assigned to aerospace by 20%-25%. And at $75 billion, aviation still represents more than half of GE industrial’s total enterprise value on a sum-of-the parts basis.

We believe our implied enterprise value for GE’s aerospace operations is double that of the most bearish valuations. In our view, the key to the bears’ thesis on the value (or lack thereof) of GE Aviation includes recent efforts to discredit the contribution from narrow-body services after a difficult second quarter. Even with an additional two quarters’ worth of data points, the bearish view is unchanged. In 2019, narrow bodies contributed about 42% of commercial services revenue, with wide bodies contributing about 46%. We think bear estimates imply that narrow bodies constituted only about 35% of GE’s commercial aviation aftermarket mix during the second quarter of 2020. But with the benefit of two additional quarters’ worth of data points, we calculate that GE’s full-year narrow-body mix may have slightly improved upon the previous year’s figures, and we expect narrow bodies will nearly become a majority of GE’s commercial aftermarket mix during the latter stages of our explicit forecast.

Our estimates imply that GE produced narrow-body aftermarket revenue of $3.6 billion, or about 44% of the overall aftermarket mix. That figure puts GE Aviation’s narrow-body aftermarket sales at about 4.5% of total GE 2020 revenue, which bakes in sales from GE Capital. That’s far greater than the 3% of total GE sales from bears’ estimates we surveyed. We somewhat agree with bears’ estimates that total GE Aviation aftermarket sales represent about 10% of GE’s total sales mix; we just disagree on the mix contribution from narrow bodies.

Because narrow bodies represent a more substantive growth opportunity for GE, contribution assumptions can have a material effect on valuation. Smaller aircraft are more fuel efficient, release fewer carbon emissions, are less noisy, and let airlines match supply more closely with demand. Therefore, narrow-body aircraft are retired far later than wide-body aircraft since they are generally more profitable to operate. Also, narrow bodies receive significantly more wear and tear as they fly shorter routes and accumulate far greater cycles in a shorter period, leading to greater parts and service revenue, which is ultimately how engine manufacturers generate profitability during the life of an engine program, since engines are sold at a loss.

If anything, we expect that COVID-19 could accelerate this long-term trend. We expect domestic air travel will recover at a relative faster clip in the near term simply because of government restrictions on international air travel related to the pandemic.

We expect that the need for scheduling flexibility due to current low demand, lower narrow-body operational costs, and the ability to fly nonstop to more destinations with better economics than wide bodies will only accelerate the shift to narrow bodies.

All these factors are to GE’s advantage, since we estimate that the more profitable narrow bodies will nearly represent a majority of its commercial aviation service mix by the end of our five-year explicit forecast. GE has more narrow bodies that are 10 years or younger than the rest of the industry, and 62% of its total fleet has seen one shop visit or less.

We think having a young fleet is a key asset that protects GE from suffering higher retirements due to the grounding of aircraft related to the pandemic. While we agree with IATA that it will take until 2024 for the commercial aerospace market to recover to 2019 prepandemic levels, these variables also lead us to conclude the GE’s narrow-body aftermarket sales can recover sooner, during early 2023.

Finally, as GE aircraft engine partner Safran’s CEO has pointed out, deferring maintenance and cutting shop visits in parts over 18-24 months could cost airline customers 20%-30% more compared with a single shop visit. We believe these factors are unappreciated upside risks to bears’ assumptions that ultimately serve as an important contributor to the V-shape recovery in our earnings projections.

Healthcare Is the Unsung Hero

Bears frequently point out that GE sold its healthcare crown jewel biopharma business, which will expose lackluster operating results from the legacy healthcare unit. Nonetheless, GE Healthcare has produced results that have surprised to the upside after the biopharma sale. It turned in 16.2% GAAP operating margins in the third quarter of 2020, good for 317 basis points of sequential improvement. It then improved upon its outperformance in the fourth quarter, with GAAP operating margins of 19.7%, or a 350-basis-point improvement from a strong third quarter.

On the heels of these strong results and GE’s typical fourth-quarter positive swing in earnings, we expected full-year 2020 healthcare segment operating profit margins of about 17.3% net of restructuring. Based on its fourth-quarter 2020 earnings report, GE Healthcare turned in full-year operating margins of 17.7%, net of restructuring.

While the healthcare market is traditionally thought of as one of the most recession-proof end markets, it wasn’t spared from the impact of COVID-19. The Radiological Society of North America reported that the reduction in demand for imaging services had an abrupt and substantial impact on radiology practices, which is no surprise, given COVID’s impact on elective procedures. But despite considerable headwinds from a squeeze in hospital capital expenditures, MRI and CT scans have recovered to their prepandemic baseline of the fourth quarter of 2019. We believe this is a positive signal for the return of elective procedures, a critical piece to GE’s near- as well as long-term outlook.

We’ve heard from radiology department administrators that hospital scans rebounded quicker, but even outpatient centers are now booked up to a couple of days in advance as patient bookings came back in full by fall 2020, easily rivaling prepandemic levels. We think this especially bodes well for GE’s pharmaceutical diagnostics business, which sells imaging contrast agents, because that is the primary driver of the business.

However, we’ve also heard that administrators are approaching incremental healthcare equipment orders with caution, preferring to sit on the sidelines for now because of fears of another U.S. government-induced shutdown amid healthcare reading reimbursement rates that are in secular decline. While we acknowledge that COVID-19 cases in the United States remain a threat, we think increased scans are also positive data points for portions of GE’s healthcare systems business. In our view, this is a business whose long-term secular drivers, including a growing geriatric population in developed markets, a rising incidence of cancer, and technological advancement in diagnostic imaging instruments, along with additional opportunities in emerging markets, remain intact.

GE’s offerings, particularly in digital and precision health, are well positioned to capitalize on the key trends observed at RSNA’s December 2020 meeting. Siemens Healthineers has estimated there will be a shortage of 15 million healthcare workers globally by 2030. That’s particularly the case in radiology; IHS predicts that a U.S. shortage of radiologists and other physician specialists could climb to nearly 42,000 by 2033. We’ve seen other estimates that exceed this number.

In the United Kingdom, just 2% of radiology departments can fulfill their imaging reporting requirements within contracted hours. Offsite reads are also becoming more common in countries like Australia. All these factors lead to potentially unmet demand, which raises the importance of looming artificial intelligence offerings.

In our view, AI will play an integral role in helping practitioners improve their efficiency and streamline their workflow. As an example, the vast majority of mammograms are normal, and AI could help triage patients where there could be a potential malignant growth. Yet another use case for AI is minimizing potential incidents of medical malpractice. According to a study in Radiology, an AI algorithm based on mammograms from 32,000 women of different ages and race was significantly more accurate at predicting cancer or its absence than practices adopted in clinics.

Partial lung collapse is common in any procedure using anesthesia; a patient can go into shock, which is life-threatening. GE was the first to have U.S. Food and Drug Administration clearance for a new AI-powered X-ray device, its Critical Care Suite, for patients suffering from a collapsed lung. Approval for solutions like Critical Care Suite is important because radiologists spend hours wading through cases to identify which are truly urgent. Physicians with University Hospitals Cleveland Medical Center claim that this on-device AI solution reduces the time to detect a collapsed lung from as long as 8 hours to as little as 15 minutes.

Solutions like Critical Care Suite use GE Healthcare’s Edison software platform, which we believe proves its technology intangible assets. Edison integrates data from multiple sources and applies analytics to provide actionable insights on medical devices like X-ray machines, as in University Hospitals, as well as through the cloud and IT systems that those devices integrate with. Medical images, for instance, can be enhanced through AI, which is yet another path to monetization.

We think these solutions solve various customer pain points. First, from our understanding, they offer interoperability, which is important because of the expense of healthcare equipment, often from multiple vendors in siloed departments. Second, solutions like clinical workflow orchestration potentially cut down on practitioner time spent on nonpatient care activities. Finally, these solutions minimize the potential for practitioner error while cutting down on suboptimal repeat imagining, which costs as much as $12 billion annually.

While GE Healthcare has made significant headway toward its near- and medium-term targets of low- to mid-single-digit organic top-line growth and 25-75 basis points of margin expansion year over year as of the third quarter, we’re convinced that it has additional runway in its approximately $47 billion healthcare market because of these solutions on top of its traditional secular growth drivers.

Cash and Earnings Outlook Improves in 2021-22

While free cash flow is coming off a historic trough in 2020, we have reasons for optimism heading into 2021. GE’s 2020 fourth-quarter free cash flow totaled nearly $4.4 billion, meaningfully greater than our expectation of $3.2 billion (well above Refinitiv consensus) and $500 million greater than in the fourth quarter of 2019.

We think management’s 2021 free cash flow guidance for $2.5 billion-$4.5 billion appears completely reasonable. We’re modeling just above the midpoint of this range at $3.9 billion, even as our earnings expectations remain slightly above 2021 guidance. We expect some of the variance relates to the timing of working capital accounts, with cash being pulled forward in management’s assumptions.

The free cash flow guidance looks achievable for several reasons, despite the sale of the cash-producing biopharma business. First, we expect a $500 million carryover benefit from the $3 billion of cash preservation actions GE took in 2020, of which two thirds went to GE Aviation. Second, we expect GE’s lean initiatives should continue to drive significant working capital improvements, as we model a 10% reduction in inventory days by the end of our explicit forecast. Finally, we model a mid-single-digit rebound in sales growth, led by a recovery in GE Aviation’s commercial aerospace division, although this is above management’s guidance of overall low-single-digit organic top-line growth.

While we expect the front half of 2021 to remain a challenge for aviation traffic, IATA surveys say that two thirds of consumers still express an interest in flying in the next month to six months, while Delta said its website views are up 40% quarter over quarter. We think these data points highlight significant pent-up demand, but consumers simply aren’t comfortable yet with the risks of traveling. We believe these fears will subside as COVID-19 vaccines become more broadly available.

On the business traveler side, over half of Delta’s corporate customers expect to be traveling at 2019 levels by 2023. If there is upside to GE management’s 2021 adjusted earnings per share guidance of $0.15-$0.25, we think it will stem from a faster-than-expected commercial aerospace recovery in the back half of 2021 and a materialization of this pent-up demand as implied in our full-year forecast. If that’s the case, we think bears fail to appreciate to the huge upswing potential from operating leverage that translates to better-than-expected margin expansion, in an effect that mirrors the operating deleverage when air traffic came to a grinding halt in the front half of 2020.

We also expect lower cash outflows from prior inheritance taxes, including restructuring, pensions, and factoring reductions. This was a $4 billion headwind in 2019. While the step down to $2 billion next year that the company expects won’t be as profound as initially anticipated based on its most recent commentary around the new-build coal exit and some additional actions at GE Aviation, we nonetheless expect industrial free cash to improve from just over $600 million in 2020 to over $4.3 billion in 2022, driven primarily by earnings growth, working capital improvements, and these subsiding cash headwinds.

At a high level, the recently announced GECAS deal is slightly less accretive to our fair value estimate than we originally thought when we ran some preliminary figures after the deal was first reported by The Wall Street Journal. The disclosed deal contains less transferred liabilities than we originally expected ($4 billion of nondebt liabilities), but with 46% equity in the combined AerCap-GECAS entity. We currently see minor fair value accretion (less than a dime per share versus the $0.40-$0.50 per share we speculated previously), but this is offset by other operating puts and takes. We somewhat agree with management that the deal creates financial value, but as it stands, we think most of the potential value creation comes from an aerospace recovery in the combined leasing entity. We're also baking in additional contingent liabilities in our assumptions about what remains of GE Capital relative to GE's internal projections.

We raised our GE fair value estimate to $14.10 per share primarily to reflect an additional year of sales and operating income following our review of the 10-K filing. Additionally, GE progressed even more quickly than we anticipated on its deleveraging efforts. Most of the discrepancy was due to less meaningful pension interest-rate headwinds than we initially modeled. We think General Electric is well positioned to safely hit its target of high-single-digit free cash flow margins by 2023-24 under the steady hand of CEO Culp.