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General Electric's Shares Can Keep Rising After Surging In 2019

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About: General Electric Company (GE)
by: Adam Levine-Weinberg CFA
Adam Levine-Weinberg CFA
Long only, Deep Value, growth at reasonable price, long-term horizon
Summary

GE is on track to end 2020 with a solid (if not spectacular) balance sheet, having dramatically reduced its debt load compared to mid-2018.

GE stock looks expensive at first glance, but merely getting its underperforming divisions to mid-single-digit margins and breakeven free cash flow would drive huge improvement along both metrics.

Many investors are underestimating the long-term growth potential of GE Aviation, while overestimating its exposure to cyclical factors.

GE stock has 100%-plus upside between now and the mid-2020s.

Between the beginning of 2017 and the end of 2018, shares of General Electric (GE) lost about three-quarters of their value, crashing from above $30 into single-digit territory. However, GE stock has staged a nice recovery in 2019, rallying more than 50%. Following the company's Q3 earnings report in late October, the stock surpassed the $11 mark. GE stock has been trading near its 52-week high ever since.

There are still plenty of skeptics who see this recent rally as a selling opportunity. Indeed, prominent Wall Street analyst and GE critic Stephen Tusa hasn't budged from his $5 price target for GE stock.

Yet while new CEO Larry Culp still has plenty of work to do to clean up General Electric, the company is already showing signs of stabilization. That should enable shareholders to cash in on the substantial long-term growth potential of the company's crown jewel: GE Aviation. As a result, there's plenty of room for the rally in GE stock to continue.

The balance sheet is improving

General Electric had industrial net debt of $55 billion as of the end of 2018. However, the company is on track to reduce that amount significantly by the end of 2020 through a series of asset sales.

Earlier this year, GE completed the spinoff and merger of its transportation segment with Wabtec. In conjunction with the deal, Wabtec paid General Electric $2.8 billion for certain assets. GE may be entitled to up to $470 million in additional cash compensation related to tax benefits that Wabtec will receive due to the transaction. Additionally, GE received a 24.9% stake in Wabtec that it subsequently sold for approximately $3.4 billion.

GE has also continued to reduce its stake in Baker Hughes this year. In September, it sold a little more than a quarter of its remaining shares in the oil-and-gas services company, bringing in $3 billion of proceeds. The company's remaining investment in Baker Hughes (including a $750 million promissory note due to GE) is worth about $9 billion and is likely to be liquidated within the next couple of years.

The exterior of a Baker Hughes office building(Image source: Baker Hughes)

Most notably, GE has agreed to sell its biopharma business to Danaher for total consideration of $21.4 billion (mostly cash). This deal is set to close in early 2020. These moves, along with some smaller asset sales, are giving GE plenty of firepower to pay down debt, make pension plan contributions, and increase the GE Capital unit's capital cushion.

By the end of next year, GE's industrial net debt is likely to decline to less than $30 billion. Much of that remaining net debt will consist of the company's pension plan deficit, which may naturally decline over time if interest rates increase or the pension plan assets achieve decent long-term returns. This level of debt should be easily manageable for a company of GE's size.

Plenty of upside from fixing the broken divisions

Many bears point to GE's apparently high valuation as a reason to stay away. The company expects to produce adjusted EPS between $0.55 and $0.65 and $0-$2 billion of free cash flow this year. Even based on the high ends of those ranges, GE stock currently trades for more than 17 times earnings and about 50 times free cash flow.

However, GE's profitability and cash flow are currently depressed because of restructuring charges, legacy costs related to its struggling power and renewables units, and poor operating performance at GE Power in particular. Many of these profit headwinds will fade naturally over the next couple of years. Others will dissipate as long as GE's restructuring actions pay off. As a result, GE stock is a lot cheaper than it looks.

Indeed, GE has said that the power segment should post a modest profit in 2019, while the renewables business will only break even. (On a combined basis, those segments lost nearly $400 million in the first half of the year.) Achieving a modest 5% operating margin for those two businesses combined would boost GE's after-tax profit by more than $1 billion (about $0.13 to $0.15 per share). In addition, reduced corporate overhead spending and a return to breakeven performance at GE Capital would add hundreds of millions of dollars to the bottom line.

Looking at cash flow, the upside opportunity is even more significant. GE Power burned through $2.7 billion of cash last year, and management expects even greater cash burn in 2019. (See slide 13.) The renewables segment is also expected to be free cash flow negative this year. If those divisions can merely produce breakeven (let alone positive) free cash flow by 2021, it would boost GE's free cash flow by more than $3 billion. That would dramatically reduce GE stock's free cash flow multiple.

A GE gas turbine(Breakeven free cash flow would represent a huge improvement for GE Power. Image source: General Electric.)

It's true that GE's asset sales will impact its cash flow. However, the transportation unit was sold early in 2019, the oil-and-gas (Baker Hughes) segment's cash flow was already excluded from industrial free cash flow, and the biopharma unit currently produces annual EBITDA of just $1.2 billion. Lower interest expense related to deleveraging should offset most if not all of that lost cash flow.

GE Aviation's growth is just getting started

Thus, while GE stock has an artificially high valuation right now, its earnings and free cash flow multiples (especially the latter) will contract significantly as long as GE's turnaround plan is modestly successful. The stock's current valuation is roughly appropriate if you expect the power, renewables, and GE Capital segments to return to modest profitability and positive free cash flow by 2021 or 2022 and assume the company will grow slowly thereafter.

However, GE Aviation is not a slow-growth business. Organic revenue growth averaged 8.1% in the 2017-2018 period, with revenue rising from $26.2 billion to $30.6 billion. Revenue grew 8.3% to $23.9 billion in the first nine months of 2019. Additionally, orders exceeded revenue by more than $2 billion over this period, setting the stage for future growth. (Orders have continued to flow in since the beginning of Q4, as well.)

Considering that GE Aviation now generates more revenue than the power and renewables businesses combined while boasting a 20% operating margin and high free cash flow conversion, this growth should not be overlooked. GE's order backlog for commercial engines and services exceeds $200 billion. Meanwhile, management expects revenue from the military side of its aviation business to surge from $4.7 billion in 2019 to $8.3 billion by 2025.

These factors put GE Aviation on track for mid-to-high single-digit growth in revenue, earnings, and cash flow over the next decade.

The "riskiness" of this growth is widely misunderstood, even by some in the analyst community. Many investors assume that GE Aviation would run into trouble if economic growth slows. If the company made money by selling aircraft engines on a short-cycle basis to airlines looking to grow, that would be true.

In reality, GE's commercial jet engines are sold years before they are delivered. Between airlines looking to grow and airlines needing to replace older jets, there is a good deal of flexibility to shift deliveries around to meet demand. Moreover, GE Aviation gets the vast majority of its profit from long-term services contracts. A slowdown in demand from airlines could lead to a slowdown in orders. Yet that wouldn't impact production for several years (if at all), and that in turn wouldn't impact service revenue for at least five more years.

In a recession, airlines might reduce aircraft utilization, leading to less-frequent maintenance events and modest revenue pressure for GE Aviation. But airlines can't stop maintaining their engines altogether. Meanwhile, the installed base of GE engines (and particularly engines made by its CFM joint venture) is set to rocket higher over the next decade, driving long-term growth in high-margin services revenue.

A slide showing the projected growth in service events for CFM engines(Source: GE Aviation June 2019 Analyst Briefing, slide 7)

From year to year, there are puts and takes that impact GE Aviation's revenue, earnings, and cash flow. But by the mid-2020s, the segment's revenue and operating income should reach roughly $50 billion and $10 billion, respectively. That's a lot of growth for investors to look forward to.

GE stock has room to run

Management expects GE Aviation to deliver earnings slightly higher than last year's $6.5 billion and free cash flow in line with last year's $4.2 billion during 2019. The ongoing grounding of the Boeing 737 MAX could actually cause GE to miss its 2019 cash flow guidance, as the CFM joint venture is not getting paid in full for all of the engines it is building.

However, once 737 MAX deliveries resume (probably in Q1 2020), GE Aviation's free cash flow will start growing again. Falling production costs for CFM's LEAP engines and services growth should bolster cash flow over the next couple of years.

To be fair, there will be some countervailing headwinds during this period as GE ramps up production of its new GE9X engine for the Boeing 777X family. But the headwind from high initial production costs for that new engine should dissipate rapidly in 2022 and beyond. That would pave the way for accelerated growth in free cash flow.

Based on my estimate that GE Aviation's segment profit may grow to $10 billion and a potential (after-tax) free cash flow conversion ratio of 70% to 80%, GE Aviation's free cash flow could soar more than 50% to $7 billion-$8 billion by the mid-2020s. Even with only modest earnings and cash flow growth for the rest of the business, GE's overall cash flow could rise to $10 billion or more.

GE stock's market cap is currently stuck near $100 billion. At a fairly moderate valuation of 20 times free cash flow, GE's market cap could double to $200 billion if free cash flow grows to $10 billion. Assuming the company resumes share buybacks at some point in the early 2020s, the upside for GE stock would be even higher. While GE has come a long way over the past year, there's ample room for further gains.

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Disclosure: I am/we are long GE, WAB. 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.