Investors are starting to believe in General Electric (NYSE:GE) again. GE stock has rallied some 54% from August lows. And there’s a case that the rally can continue.
After all, the bull case for General Electric stock rests on a turnaround engineered by chief executive officer Larry Culp. Culp transformed Danaher (NYSE:DHR) into a technology powerhouse; Danaher stock rose some 530% during his 14-year tenure.
Culp’s appointment as General Electric’s CEO on Oct. 1, 2018 was greeted with hopes that Culp could work similar magic: GE stock rose 7.1% on the news. But that enthusiasm has dimmed over time. Even with the rally over the past five months, General Electric shares are up less than 2% in the fifteen-plus months since Culp’s hiring was announced.
The lack of upside so far suggests that more upside could be on the way if General Electric can drive the hoped-for turnaround. That’s still a huge ‘if,’ however. Fourth quarter earnings on Jan. 29 will be huge in establishing how much progress GE is making — and how much confidence investors can have in its future.
Why Q4 Earnings Won’t Change the Case
The fourth quarter numbers themselves may not be all that important. Analyst estimates are soft, with the Street looking for earnings per share to climb a penny year-over-year on revenue down 23.5%.
The top line pressure isn’t necessarily the sign of a declining business. GE Aviation likely will see short-term pressure from the 737 MAX issues at key customer Boeing (NYSE:BA). And a reduction in the company’s stake in Baker Hughes (NYSE:BKR) means that business no longer will be part of GE’s consolidated financials.
Q4 almost certainly isn’t going to be impressive. Of course, that won’t surprise anyone who’s been paying attention. These two short-term factors will hit the reported numbers. And from a long-term standpoint, even Culp himself has emphasized more than once that the turnaround here will take time.
The one number that will be closely watched is free cash flow. General Electric already has raised its outlook twice this year, and needs to hit its target. The gap between earnings and cash flow long has been a problem for GE stock. It was a key part of the (admittedly questionable) short seller report that sent shares tumbling briefly last year. And disappointing cash flow generation contributed to the two dividend cuts seen in recent years.
Reaching the current forecast of roughly $2 billion in industrial cash flow (which excludes contributions from GE Capital) would be a step toward restoring GE’s credibility. That aside, Q4 numbers, barring a huge surprise, seem highly unlikely to change sentiment toward General Electric.
But that doesn’t mean the fourth quarter release doesn’t matter. It does.
Why the Q4 Earnings Release Might Change the Case
The focus won’t be on the backward-looking numbers for a quarter affected by external factors. It’s going to be on 2020 guidance.
Again, General Electric has a long road ahead. Success is not guaranteed. As Dirk Hackbarth, Professor of Finance at the Boston University Questrom School of Business, told InvestorPlace:
“Given its rebound, GE’s future seems to be less of a “continued turnaround” and more one of a “strategic disinvestment” of its non-core pieces for the best prices it can get…Moreover, the proceeds from asset sales and spin-offs should be used to gradually de-lever GE to a level that is more in line with its profitability (e.g. return on assets) going forward.”
The bull case is that this will become a “leaner and meaner” General Electric. And so it would do wonders for GE stock if the company can show some progress this year. Right now, analysts aren’t sure it will. Wall Street estimates for 2020 earnings per share currently have a wide range: the low estimate, according to Yahoo! Finance, is 49 cents, while the most bullish projection sits at 77 cents.
That range isn’t surprising given that analyst price targets too have a large split, as Hackbarth pointed out and Barron’s noted last year. At the moment, the most bearish analyst (which I believe is Morgan Stanley’s Stephen Tusa, long a GE skeptic) values GE stock at $5. The high target is $14.
In that context, the 2020 outlook becomes exceedingly important. Full-year 2019 adjusted EPS should come in around 61 cents. If GE guides toward the low end of Street estimates, GE stock quickly looks overvalued. Investors are paying something close to 20x earnings — and a higher multiple to free cash flow — for a business still in decline.
If GE supports more bullish expectations, however, this story gets much more interesting in a hurry. Guidance for, say, 70 cents would imply double-digit profit growth in 2020. Yet GE stock would be trading at roughly 17x that guidance. Rival Honeywell (NYSE:HON) trades at 21x 2020 consensus earnings with single-digit growth expected.
A Big Stretch for GE Stock
Again, next week’s release won’t prove that GE is destined for a turnaround — or that it’s doomed to further declines. But 2020 guidance, in particular, well may establish the direction of General Electric stock for several months, if not the rest of this year.
It could go either way. GE stock could look very different depending on the trajectory established by 2020 results. Hackbarth forecast that the stock “more likely stabilizes in the current price range” this year. If 2020 performance in line with current expectations, that forecast is probably correct.
But if GE can surprise to the upside, the story improves. GE has “many attractive parts,” as Hackbarth put it. Aviation should benefit from long-term air travel demand. Healthcare has real potential, as I detailed last month. GE Power has substantial room for improvement. Those three units underpin the bull case here.
That bull case, however, exists mostly on paper for now. It’s up to Culp and GE to turn that theoretical potential into practical returns and cash flow. A confident outlook for 2020 can drive more confidence on that front, and thus more confidence in GE stock.
As of this writing, Vince Martin has no positions in any securities mentioned.