GE Will Take Longer to Get out of a Hole; Lower FVE

Narrow-moat-rated General Electric GE had a difficult second quarter. That was expected. GE’s higher margin businesses within aviation, healthcare, and gas power were more heavily impacted by coronavirus and were down three times relative to the rest of GE Industrial. While we arguably overly anticipated the revenue pressures, we failed to fully appreciate the magnitude of difficulties management faces in excising fixed costs from GE’s business. To that end, we cut our fair value estimate by about 6.5% to $9.90 (from $10.60 previously). We now expect adjusted EPS of $0.05 for full-year 2020, $0.47 in 2021, and $0.71 in 2022, as well as industrial free cash flow burn of just over negative $2 billion for 2020. Our valuation implies a value of roughly 21 times our 2021 earnings expectations. Given the unique challenges in the commercial aerospace industry, we encourage investors to look out to next year’s earnings, despite the clear level of macroeconomic uncertainty (which should be appropriately built into an investor’s margin of safety).

While there were numerous puts and takes in our model, one was by far the most material--Aviation decremental margins. Two data points influenced our thinking here. First, the most recent quarterly results. On a headline basis, GE’s decremental margin only improved sequentially from about 62% in the first quarter to about 59% in the second quarter. A sizable portion of that was due to charges in aviation’s CSA contracts related to COVID-19, to the tune of about $600 million, reflecting factors like lower engine utilization, contract modifications, customer fleet restructuring (our aerospace analyst estimates retirements represent about 4.25% of the global fleet to date since COVID-19, based on Boeing CEO Dave Calhoun’s comments), and higher bad expense, among others. CEO Larry Culp had previously mentioned this at a late May investor conference (“probably in the hundred of millions of dollars”).

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