Photograph by Sebastien Bozon/AFP/Getty Images
(GE): cash flow and fixing the ailing power division. That’s not all that matters for the long-term success of the company, though.
After the investor event Thursday, a bevy of analyst notes appeared, opining on industrial free cash flow and CEO Larry Culp’s ability to turn around GE Power. The company’s 2019 earnings—and why its earnings don’t matter—are other popular topics for Wall Street analysts these days, along with debt reduction.
All four issues are important to GE, but investors shouldn’t forget about one other big thing: aftermarket parts and services for the company’s turbines, engines, and health-care equipment. Understanding this market can help predict what cash flow will look like after the turnaround is complete.
UBS analyst Peter Lennox-King tracks the number of times different phrases are mentioned on earnings calls. It’s an interesting metric that illustrates what the Street focused on. During GE’s fourth-quarter earnings report on Jan. 31, the word “services” didn’t crack the top 10. “Cash flow” was king on that call.
After Thursday’s event, services didn’t come up much either in analyst notes. Melius Research analyst Scott Davis commented that free cash flow in the renewable business was disappointing. “[The wind business] is super competitive and lacks the aftermarket service potential to compensate for the low [original equipment] profile,” he wrote. Davis thinks GE may exit the renewable-power-generation business.
Like Davis’ comment implies, parts and service margins tend to be higher than margins on original equipment. But how much higher? Consider aerospace supplier
(TDG), which has operating margins north of 40%. TransDigm generates most of its sales in the aviation aftermarket—replacing parts as they wear over time.
(HON), by contrast, also has a large aerospace parts and service business, and it has a large original-equipment franchise. Honeywell’s aerospace margins are a healthy 23%, but that’s a far cry from TransDigm’s levels. On Honeywell’s fourth-quarter conference call, management told analysts that higher original-equipment shipments were a drag on overall aerospace margins.
We can use some of this information to get a better sense of what GE’s cash-flow potential is on its remaining industrial assets after the bulk of the restructuring is completed this year. Barron’s estimates that GE’s remaining industrial assets could generate at least $6 billion in annual cash flow.
Is our number right? Probably not. But it’s a useful rule of thumb. And treating original-equipment businesses like low-margin loss leaders to forecast the future reframes the cash-generation potential of the GE service franchise. The losses from market declines in power, in other words, are masking higher potential margins in parts and services.
No one is talking about service margins right now, but if Culp can cut fixed costs, then service margins will take center stage in the future.
GE wasn’t immediately available to respond to Barron’s questions about service margins. GE shares are down 2.9% in Friday afternoon trading, to $10.00, and up 37.4% year to date.
Write to Al Root at [email protected]