- General Electric's free cash flow declined significantly in 2019, but still beat the company's initial full-year guidance by a wide margin.
- GE expects further cash flow improvement in 2020, despite headwinds from its asset sales.
- Free cash flow is poised to rocket higher over the next two years as the power and renewables segments start generating cash again.
- Annual free cash flow could reach $10 billion by the mid-2020s, making GE stock a great buy based on its current market cap of about $75 billion.
During 2019, General Electric (NYSE:GE) finally returned to relative stability after two awful years during which GE shares lost more than three quarters of their value. It was hardly a spectacular year, to be sure. Free cash flow fell nearly 50% year over year to $2.3 billion, and while adjusted EPS rose 14% (from $0.57 to $0.65), that was still less than half of the $1.49 GE reported for adjusted EPS in 2016.
Still, it was impressive that GE started to consistently beat and raise its guidance in 2019, after dramatically missing its forecasts in 2017 and 2018. Most notably, GE's full-year free cash flow of $2.3 billion was far better than the company's initial projection that it would burn $0-$2 billion of cash in 2019.
Last week, General Electric held its much-anticipated 2020 investor outlook call. During the call, GE described a multiyear plan to drive significant free cash flow growth over the next few years. Here's why investors should be optimistic about the prospect of significant improvement in the conglomerate's cash flow.
The 2020 outlook in brief
In late January, GE projected that it would generate $2 billion-$4 billion of industrial free cash flow in 2020. Last week, the company reaffirmed that projection, despite now expecting that the COVID-19 outbreak will reduce free cash flow by $300 million-$500 million in Q1, causing the company to burn approximately $2 billion this quarter.
Notably, GE's 2020 guidance doesn't incorporate any estimate of the potential impact of COVID-19 beyond the first quarter. The outbreak could significantly reduce free cash flow in a worst-case scenario. However, as CEO Larry Culp explained on the guidance call (see p. 16), "I think we decidedly did not take a view and would not necessarily encourage any extrapolations from what we've said here in the first quarter simply because what we don't know outweighs what we do know at this point in time."
Leaving this risk aside, GE's outlook calls for substantial cash flow improvement on a like-for-like basis. After all, GE still expects to complete the sale of its biopharma unit to Danaher (DHR) this quarter. Adjusting for that deal and other portfolio changes, GE's baseline 2019 free cash flow would have been just shy of $1 billion.
(Source: GE 2020 Investor Outlook Presentation, slide 41)
The biggest source of year-over-year cash flow improvement will be lower "inheritance items", such as cash used for legal settlements, restructuring, and unfavorable contracts. Working capital changes, which represented a $2.8 billion drag (see slide 5) on free cash flow last year, will be a much smaller headwind in 2020. Higher cash taxes and timing issues will partially offset these tailwinds.
Room for improvement in power and renewables
The most interesting part of GE's presentation was its multiyear forecast for continued cash flow improvement. At a high level, Culp said to expect high-single-digit free cash flow margins over the long term, which would imply annual free cash flow of roughly $7-$8 billion. While Culp didn't put a firm date on hitting that milestone, it looks to be reachable within 2-3 years. That would put GE well on its way towards my expectation of $10 billion in annual free cash flow by the mid-2020s.
The biggest source of improvement over the next two years will come from completing the turnarounds of the power and renewables segments. Together, they burned $2.5 billion last year, and GE expects limited improvement in 2020, with better results at GE Power partially offset by even greater cash burn in the renewables segment.
In both power and renewables, underperforming deals signed in 2016 and earlier have hurt free cash flow in recent years. The natural runoff of those deals is contributing to long-term cash flow improvements for both segments. GE has also cut costs in both business units and shifted its emphasis to profitability over growth, mainly via more conservative underwriting of new deals. And in renewables, the offshore wind business will begin generating revenue in 2021, when its Haliade-X turbine will begin shipping.
As a result, the power and renewables segments are likely to return to positive free cash flow soon regardless of market conditions. Currently, management projects that GE Power will start generating free cash flow in 2021, with further improvement in 2022, while the renewables business will move closer to cash breakeven next year before producing positive free cash flow in 2022.
(Source: GE 2020 Investor Outlook Presentation, slide 42)
Growth will continue in aviation and healthcare
Meanwhile, GE expects continued strong performance from its secular growth businesses: aviation and healthcare. GE Aviation is the company's main cash cow, contributing $4.4 billion of free cash flow last year. Management is calling for free cash flow in line with or slightly better than that figure in 2020, despite the 737 MAX grounding and a sharp drop in air traffic in Q1 (particularly in Asia). This highlights the segment's resiliency in the face of short-term disruption.
Given the high likelihood that the 737 MAX will return to service sometime in 2020 and the current COVID-19 panic will recede later this year, GE Aviation is likely to return to strong growth in 2021 and beyond. The expansion of the middle class globally and the declining cost of air travel has driven strong growth in air traffic over the past decade, and that trend isn't going away. Furthermore, GE Aviation ended 2019 with a massive $273 billion backlog (equal to 8 years of revenue), mainly consisting of long-term services contracts.
Healthcare is a slower-growth business but also holds plenty of potential. Excluding $1.5 billion of income from the biopharma business that is being sold, GE Healthcare earned $2.4 billion last year. The segment has ample room for margin expansion and is capable of high free cash flow conversion. As a result, within 2-3 years, GE Healthcare could match or exceed the $2.5 billion of free cash flow it produced in 2019, despite having sold the high-margin biopharma business.
A great time to buy
GE stock has plummeted due to the COVID-19 panic. Just a month ago, it hit a 52-week high above $13. By contrast, the stock closed at $8.21 on Monday, despite the bullish outlook issued last week.
Over the past two years, GE has dramatically improved its balance sheet, and it is likely to complete that process soon by closing the biopharma sale. That will give it a massive cushion to withstand any short-term disruption to its business from COVID-19. Meanwhile, the services-heavy nature of GE's business would partially insulate it from the impact of a recession.
As a result, GE is well positioned to boost free cash flow to the $7-$8 billion level by 2022 or 2023. There's plenty of room for growth beyond that point, driven by the secular growth of the aviation and healthcare businesses, as well as continued margin improvements for power and renewables. This strong baseline level of cash production will give GE plenty of firepower to deal with whatever headwinds inevitably crop up in the future.
With GE's market cap having plunged from more than $110 billion just a month ago to around $75 billion today, GE stock is trading at a massive discount to fair value based on its future cash flow potential. For investors willing to ride out the current period of volatility, GE stock has room to double over the next few years, far outpacing the market.
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