GE's Future Is Brighter Than Its Recent Past

General Electric GE reported fourth-quarter results that blew well past our revenue assumptions for the year. However, it fell slightly short of our below-consensus adjusted earnings per share estimate and, more important, exceeded our GAAP EPS expectations. Top-line growth 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 $0.19 against $0.17 of actual results (versus $0.22 for consensus estimates). Adjusted industrial free cash flow generation of $4.5 billion was the most important item this quarter. Free cash flow swung positive thanks to 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 per share. We also maintain our narrow moat, stable trend, very high uncertainty, and poor stewardship ratings. Although the earnings call was light on details regarding the future and lacked the guidance analysts wanted to hear, we view the company’s results, as well as its free cash flow generation, as a welcome 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 before investing.

Disciplined investors should know that the risk of investing in GE has 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, the shares continue to trade below our combined stand-alone valuation of GE Aviation and GE Healthcare (about $11 per share), even after incorporating all the company’s total calculated liabilities. Investors still get liquid assets like GE’s 50.4% interest in BHGE, which trades in the public market, essentially for free. As another reference point, CEO Larry Culp bought 225,000 GE shares at a price of $9.73 in November.

The most important items on the call came around additional details on the company’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 Financial Institutions Reform, Recovery, and Enforcement Act 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 that Bank of America paid in 2014 for its Countrywide portfolio. Additionally, for now, the annual insurance test conducted in the fourth quarter revealed a relatively minor $65 million aftertax charge compared with some of the inflated estimates from the Street. More important, 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 are maintaining our current reserve shortfall on the insurance front at just shy of $4 billion for GE Capital out of an abundance of conservatism. Interestingly, the company 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 GE Capital as worth $0.49 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 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 head count is down 15% and footprint is 30% smaller 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 affects profitability as the engine is still in ramp. CFO 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. However, Miller 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 is intact, despite analyst concerns that GE will lose one of its highest-cash-generating units. The plan now seems to be selling just under 50% of Healthcare while 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 GE Capital’s debt (which GE is on the hook for) and GE industrial’s debt separately, which we do in our own analysis. We also appreciate that the company 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 Jeff Immelt and John Flannery and fall well short of his projections. We prefer Culp comes up with realistic numbers that are achievable and that the company 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 Culp will successfully lead a multiyear turnaround for the company.