What the Market Missed from General Electric's Q4 Earnings Report

If you listened to the marketing hype about a certain recent football matchup, you might have thought that the game between the Patriots and the Rams was historic! Amazing! Epic! Worth the $120 price tag for the commemorative jersey! If, on the other hand, if you actually watched it -- or rather, endured it -- you know that the reality didn't match the hype (I dubbed it the Stupor Bowl).

Something similar happened a few days before the big game. When battered industrial conglomerate General Electric (NYSE:GE) reported fourth-quarter earnings, shares jumped 11.7%! But if you actually read the earnings report and listened to the quarterly conference call, you might wonder why the market reacted the way it did. Here's what the market apparently missed from GE's report.

Like a losing football team, General Electric has disappointed its fans with underperformance. Image source: Getty Images.

He's got the power

Certainly, there were some bits of good news in the earnings report: GE Aviation -- as always -- was a bright spot in the portfolio. And it looks like the company's asset sales combined with the recent dividend cut may allow GE to deleverage its balance sheet more quickly than expected. 

But the elephant in the room is the underperforming Power unit. Some analysts cheered how new CEO Larry Culp seems to "get it" when it comes to how much of a drag GE's Power division is on its overall performance. And it's true that Culp made clear on the earnings call what level of scrutiny the troubled unit would demand:

For Power, we are resetting the baseline. We are reviewing every single project and contract and digging deeper to understand costs and benefits with respect to restructuring market and commercial execution, improvement opportunities, legacy project issues, and our service operations. We're gaining more meaningful insights into the past for near- and long-term earnings and cash potential of this business.

Later on the call, he identified "strengthening the businesses, starting with Power" as one of his two top priorities for the company, along with deleveraging.

But his prescription for exactly how he intends to do that was pretty vague. He and CFO Jamie Miller indicated they believe the weaknesses in the heavy-duty gas turbine market are finally bottoming out -- flat for the next couple of years, according to Miller, with a "flat to slightly down" overall 2019 power market, according to Culp. But nobody was prepared to provide any specific guidance about what to expect from the unit. Culp promised such an update "in the near term" once he has developed "more conviction around the cash flow situation of Power."

Speaking of that cash flow situation, Culp wouldn't even speculate whether Power's free-cash-flow burn -- which hit $2.7 billion in 2018 --  would be any better this year, in response to a question by analyst Joe Ritchie of Goldman Sachs. It makes sense that Culp isn't going to tip his hand on guidance, but not knowing exactly what's in store for Power -- which everyone knows is the company's biggest weak spot -- makes it tough to be bullish on the company as a whole. 

The executioner

If we can't get a straight answer about what kind of performance to expect from Power in the near term, we should at least be able to get a sense of what the company is doing to turn things around there. Here, Culp provided more clarity...at least on the surface. He clearly identified three "root causes" of Power's problems:

Hesitation to embrace the fact that the cyclical Power market was in a downturn. Nonoperational headwinds, including legal settlements and "legacy project erosion" from the ill-fated Alstom acquisition. Poor execution. 

Culp points out that the blinders are off about the Power market, and that GE has cut costs at Power to try to adjust the cost structure to this new normal: The company laid off 10,000 Power workers (15% of the segment's workforce), shrank its footprint by 30%, and cut $900 million of base costs. He expects to cut an additional $300 million (19%) out of the $1.6 billion budget for the unit's headquarters. That seems like a solid amount of cost-cutting, but by itself, it's unclear whether it will offset that $2.7 billion of free cash burn. 

The nonoperational headwinds, according to Culp, should hit a "high-water mark" this year. But even if that gets those first two root causes of Power's problems under control, the big one -- that the Power unit simply needs to execute better -- still needs to be addressed.

Fail better

Culp listed some anecdotal prescriptions to mitigate the unit's execution problems: consolidating management teams and pursuing better risk assessment. But those seem unlikely to move the needle much. In fact, on the call, Deutsche Bank analyst Nicole DeBlase challenged Culp to provide a better answer, asking point blank, "What exactly are you doing to improve Power execution, since that keeps coming up as a driver of weaker profitability, and when might we stop talking about that piece of the margin headwinds?"

Culp responded with a heaping helping of word salad:

Well, Nicole, I would say we are in the very early innings relative to the turnaround at Power. I don't know how else to frame it. Again, a new team, a new structure, new operating rhythms.

When we talk about execution, we talk about daily management. What I'm really referring to is making sure that every day, the folks in the field -- the folks in the factories, the folks in the labs -- understand what the key operating metrics are that they are responsible for, that feed into better margins both at the growth and the operating level in this business.

So that takes time because it's not just a reporting exercise, right? It's a management exercise and making sure they understand not only how they're being measured but how to go about actually getting better price, how to go about actually driving better material productivity.

Execution in the field, as well; not only around cost, but frankly -- more importantly -- around quality: making sure we get into outages quickly and we solve issues for customers the first time and when we're not going back. Those are the source of things. And it is a big organization. It's a global organization. This is going to take a little while. But I'm optimistic that we'll see it in our operating metrics over time, and that will in turn translate into better performance. We'll clearly get some lift sooner from the absence of the adjustments that we made at the end of the year. But what I'm really focused on, and what I think investors are to be focused on, are those underlying operating improvements.

So it appears that this all boils down to "better management," which as a turnaround prescription seems like pretty weak sauce. 

What it all means

Even GE's top brass admits that turning Power around is going to take time. But nobody knows how much time. And until then, Power is going to be a drag on GE Aviation and on the company's overall cash flow. But nobody is willing to guess how much of a drag it's going to be. It's great that Culp recognizes that this is a problem, but at least at present, it still seems to be a problem without an obvious solution.

Maybe Culp is going to pull the rabbit out of the hat and surprise everyone with a strategic masterstroke. But right now, the plan seems to be to just make incremental improvements and otherwise tough it out. Kind of like punting the football for eight consecutive drives and hoping to eventually get into field goal position. That doesn't seem like the kind of plan that warrants a double-digit jump in share price.