Harsh Realities Ahead for GE

At GE's long-anticipated investor update this week, CEO John Flannery reset expectations to reflect the harsh realities of what we believe will likely be a multiyear turnaround. With the dividend cut by half to $0.48 per share, significant restructuring planned for the power segment, and no imminent breakup of the industrial conglomerate on the table, we believe maximum pessimism has been reached.

In these early days of Flannery's tenure, we like that his messaging repeatedly addresses questions we consider most important to investors: How will GE improve its free cash flow, and how will the company allocate that cash going forward? Cutting the dividend is painful, but it frees capital to allocate toward restructuring. Flannery also highlighted $20 billion of assets earmarked for divestiture over the next two years, including transportation, lighting, and up to 10 other smaller businesses, a sign of purposeful redirection of capital and management attention toward businesses with strong potential for secular growth. Finally, management incentives will be pegged to free cash flow performance, a change we welcome to better align the company's interests with shareholders'.

Following this weeks sharp sell-off, GE shares are trading at a level that implies that the portfolio is incapable of returning to meaningful earnings growth; however, we do not believe this reflects the company's longer-term potential, considering that 70% of GE's revenue and 85% of its earnings come from businesses that dominate their markets. While we acknowledge that 2018 will be messy, and that 2018 earnings will exhibit a lot of accounting and restructuring noise, we assert that GE's collection of assets can return to healthy free cash flow generation over the long run under today's better management.

In light of this week's investor update, we have reduced our expectations for midcycle margins and in turn have cut our fair value estimate to about $26.