One of the most interesting companies these days has got to be General Electric (NYSE:GE). After falling from grace in the eyes of investors and eventually being removed from the Dow Jones Industrial Average’s list of 30 stocks, a spot it has held continuously since 1907, the conglomerate announced plans to undergo a significant restructuring. However, on July 20th of this year, another event is coming to pass: management is slated to report earnings for the second quarter of the company’s 2018 fiscal year. Heading into earnings time, there are some items I have identified, especially now that major changes have been announced to how the business will operate in the future, that investors in the business and watchers of the stock should keep a close eye on.
Power: continued trouble on its way
Regular readers of mine know how I feel about General Electric’s Power segment: if it were up to me, management would divest of the business or at least some portion of it. I have expressed this in other articles in the past, and I lamented management’s inaction on this when the firm came out and announced its plans for the future. Simply put, the segment is at the early stages of what will look like a multi-year downturn as competition and weak demand for gas turbines negatively affects performance. By monetizing this asset, the firm could allocate capital elsewhere, like its robust and profitable Aviation segment or on its Digital operations.
Sadly, this quarter, I expect no positive change for Power. If anything, the picture will be worse than it was in the first quarter of this year. In the first quarter, Power generated sales of $7.222 billion, a decrease of 9% compared to the $7.940 billion reported the same quarter a year earlier. This was driven in large part by the sale of just 12 gas turbines compared to the 20 seen a year before that. Meanwhile, segment profit declined 37.7% from $438 million to $273 million.
In the second quarter of last year, results were stronger than the same quarter of 2016, with revenue up 5%, but segment profit contracted 10% year over year, falling from $1.14 billion to $1.03 billion. I do believe there’s a strong chance that profits from the first quarter of 2017 to the second quarter will grow, but the year-over-year sales decline should be significant. After all, management is currently forecasting that industry sales this year will amount to perhaps fewer than 30 GW (gigawatts), down from their prior forecast of 30 to 34 GW. Given increased fuel efficiency as well, this trend should continue for a few years.
Of course, this doesn’t mean that everything will be positive. Though the decrease in sales had a major negative impact on the segment’s margin, which declined from 5.5% in last year’s first quarter to 3.8% this year’s, management touted some success in what they are referring to as “structural” costs. In 2017, management claims to have reduced this figure by $800 million, while in the first quarter of this year, they lowered costs by $350 million with the expectation this year of $1 billion in savings. I actually believe management will up this figure in their second quarter, but investors should be aware of the pitfalls of relying on such an abstract measure. With no clear definition and no data provided by investors to consolidate an estimate of this nature in accordance with GAAP, management can technically say anything they want, and it will have little impact until we see sales grow back in the future and notice whether or not the savings have resulted in margin expansion that otherwise would not be explained.
Additional guidance should come
When management announced last month that they were going to restructure the company, I was generally supportive of their goal, but there’s still a lot of information that hasn’t been discussed. For starters, the company said that they intend to divest of their Healthcare segment by selling off around 20% of that business’s equity and spinning off the rest. Details today are still scarce. I had suggested that Warren Buffett’s Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) might be a good acquirer, especially with his company’s partnership with Amazon (NASDAQ:AMZN) and J.P. Morgan Chase (NYSE:JPM), but that may very well not come to pass.
Beyond the divestiture of General Electric’s Healthcare segment, management needs to provide more insight into the $25 billion worth of sales planned for GE Capital, but perhaps the biggest guidance-related issue on investors’ minds is what will become of General Electric’s distribution. Last year, the conglomerate cut its dividend for the second time since the last financial crisis, decreasing it by half to $0.48 per share each year. Given the business’s current share count, this translates into about $4.17 billion per year. Some companies, like J.P. Morgan, have said recently that the business must cut its distribution.
Whether this will happen or not remains to be seen, but I would be supportive of cutting the dividend to zero. This is because I would prefer to see the company allocate the cash toward either debt reduction or, preferably, toward growth initiatives. $4.17 billion per year is a lot of cash that could be used far more efficiently than paying shareholders. The only thing we know is that the distribution is safe for the moment. Management said that they will keep the current dividend until they divest of their Healthcare segment, after which they will “adjust” it to be in line with “industrial peers”. Some sort of discussion on this and clarification on the 12-18-month timeline for Healthcare’s separation should be watched closely.
Expect Aviation to shine
Beyond any doubt, my favorite part of General Electric has got to be its Aviation business. Over the past three years, sales at the segment have grown at a respectable rate of 5.4% per annum, growing revenue from $24.66 billion in 2015 to $27.375 billion in 2017. The real treat for shareholders, though, is the segment’s profitability. Over the same three-year time frame, segment profit expanded an impressive 20.6%, or 9.8% per annum, growing from $5.51 billion in 2015 to $6.64 billion last year. During this time frame, the segment’s profit margin expanded as well, growing from 22.3% to 24.3%.
So far, 2018 has been really kind to Aviation. According to management, the first quarter of this year saw sales of $7.112 billion, up 6.6%, from the $6.673 billion reported in the first quarter of 2017. Segment profits grew even faster, expanding 25.9% from $1.273 billion to $1.603 billion. All of this is great, but the really exciting figure is the segment’s backlog. In the first quarter of last year, this figure stood at $179.2 billion. This year’s first quarter saw the figure hit $201.6 billion, an increase of $22.4 billion, or 12.5%, year over year. As I wrote in a prior article, the Aviation industry is supposed to expand nicely alongside the global economy in the long-run. So long as there aren’t any worldwide economic downturns, and so long as management can maintain industry-leading products, this backlog increase, which has taken backlog up to 7.4 years’ worth of work using 2017 as a benchmark, suggests even greater sales and profits to come.
General Electric has been on a wild ride over the past several months, but the trip’s not over yet. I suspect that we will see some additional pain coming up soon related to the company’s Power segment, but I believe that Aviation and perhaps other parts of the conglomerate will shine. In addition, there will be a lot of developments coming up over the next several months as management transitions the company’s operations in accordance with their restructuring plans, but I suspect some of these items will be discussed in greater detail this month when management discusses second quarter results. By keeping a close eye on these developments, investors can get a glimpse of what the future might hold, which, in the case of General Electric and given how volatile the enterprise has been, could help shareholders’ quest for profits a great deal.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.