Analysts Are Wrong About the Biggest Risk for GE Stock

Shares of General Electric (NYSE: GE) are sitting near a nine-year low, yet many investors remain very bearish about the industrial conglomerate. Just in the past two weeks, analysts at two major investment banks have panned GE stock, pointing to deep problems in the company's power segment.

Yet while the power business has historically been General Electric's largest segment, it accounts for a very small proportion of GE's value today. As a result, even long-term problems in the power business are not as problematic as they might seem.

Instead, the biggest risk for GE stock is the potential for a setback in the conglomerate's crown-jewel business: aviation. Recent production miscues for a crucial new product make that risk seem a little larger today than it was just a few months ago.

More criticism of GE Power

In late August, longtime GE bear Stephen Tusa of J.P. Morgan reaffirmed his $11 price target for GE stock. (That's the lowest of any analyst from a major brokerage.) In a client note, he warned that the power business faces a "prisoner's dilemma" and must either cut prices or give up a substantial amount of market share. Either way, it could be facing further declines in its revenue and profitability.

Just a few days ago, UBS analyst Steven Winoker chimed in, cutting his price target for GE stock from $16 to $13 due to plunging demand and increasing pricing pressure in the power market. He wrote that these weak conditions could force GE Power to make deep cost cuts, potentially jeopardizing its ability to fully recover.

These warnings miss the mark

These critiques of General Electric's power business highlight how poorly the segment is performing. But management has been very transparent in this regard, calling for industry equipment demand this year to be about 40% below 2016's level -- with no recovery expected until after 2020.

For the first half of 2018, power segment revenue fell 15%, while orders tumbled 27%. Segment profit plunged 52% to $694 million under new accounting rules. Under last year's accounting rules, GE Power reported a $1.8 billion profit in the first half of 2017.

These numbers are certainly discouraging, but they also point to the power business' diminishing importance for General Electric. Power accounted for just 12% of GE's industrial segment profit in the first half of the year. By contrast, the aviation business delivered more than half of GE's industrial segment profit -- and that segment has been growing quickly.

In other words, the vast majority of GE stock's value comes from its aviation segment. That will become even more certain after the company spins off or sells off most of its businesses aside from power, renewables, and aviation. As a result, a threat to GE Aviation's growth would be far more significant for the company than further weakness in the power business.

Can GE transition successfully to new engine families?

GE and its CFM joint venture dominate the commercial jet engine business, together holding about two-thirds of the market. CFM has been particularly successful due to rising demand for next-generation narrow-body aircraft. CFM's LEAP engine family is the sole powerplant for Boeing's (NYSE: BA) 737 MAX and has more than 50% market share for the Airbus A320neo family.

However, production problems have plagued CFM recently. Earlier this year, CFM was up to seven weeks behind its plan for LEAP engine deliveries. In mid-July, executives for the joint venture said that delays were moderating and that the lost production would be made up by year's end.

Instead, the disruption to aircraft production seems to be increasing. Boeing recently had to park dozens of partly completed 737s around the airport in Renton, Washington, (adjacent to its factory) due to a shortage of LEAP engines.

Boeing has said that the worst is over and any missed deliveries for the third quarter will be made up in the fourth quarter. But there's still a risk that CFM won't be able to make good on its production recovery plans. CFM also faces significant challenges in the years ahead as LEAP engine production is scheduled to continue rising.

Looking further ahead, the recent production challenges will likely add to CFM's hesitation about committing to further output increases. That could mean slower growth for GE Aviation, implying a lower valuation for GE stock.

Boeing's pending transition from the 777 to the next-generation 777X brings its own set of risks. GE is developing its most powerful engine ever for the 777X, but order activity has been muted over the five years since sales began. Barring an acceleration in order activity, GE could struggle to recover its development costs for the GE9X engine.

Focus on what really matters

As recently as 2016, the power business generated 30% of GE's revenue and 29% of its industrial segment profit. As a result, many analysts still treat it as a key driver of the conglomerate's performance. GE Power's weak outlook has made these analysts bearish about GE stock.

Yet analysts ought to pay far more attention to GE Aviation, which is likely worth five to six times as much as the power business. If the aviation business continues its run of success over the next decade, GE stock will almost certainly perform well, regardless of what happens to the power segment.

By contrast, if the recent production problems at CFM lead to longer-term pressure on GE Aviation's growth and profitability, it would undermine the stock's value. The biggest long-term risk to GE stock can only stem from the company's most important division.

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Adam Levine-Weinberg owns shares of General Electric. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.