The news that General Electric Company (NYSE: GE) CFO Jeff Bornstein will leave at the end of the year caught the market by surprise. But how much should investors really worry about the news? After all, Bornstein is an industry veteran with 28 years of service to GE, so his departure could be a completely natural move.
However, I happen to think his departure could be something deserving close attention from investors. Here's why.
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Goodbye, Immelt and Bornstein
While the Bornstein announcement could be couched in terms of a natural succession, it's worth noting that when John Flannery was moved up to CEO, Bornstein was also promoted to vice chairman. Indeed, he was supposed to work closely with Flannery to run GE after Jeff Immelt's departure in August. It seems clear that things haven't worked out as originally expected.
While we don't know exactly what's changed, Bornstein's departure highlights a number of ongoing issues with GE's management regarding recent history with guidance and the challenges ahead to fully restore credibility with investors.
What's gone wrong with GE's guidance
GE's management has been over-promising and under-delivering, and you only have to look at the nearly 27% decline in the company's stock price this year to see the impact. GE hasn't formally abandoned its EPS targets for this year and the next, but the commentary around those targets has grown increasingly negative. Moreover, there are signs of deteriorating quality of earnings. Consider:
- GE significantly missed its own expectations for cash flow generation by $1 billion in the first quarter.
- On the second-quarter earnings call, Bornstein guided investors toward the bottom end of the full-year earnings and cash flow guidance ranges.
- Immelt's long-held target of $2 in operating EPS in 2018 is significantly above the analyst consensus of $1.63.
GE's cash flow problem
The first bullet point deserves closer inspection because GE's problems this year haven't been about just failing to meet earnings expectations--in fact earnings and guidance have remained in the ranges set at the start of the year.
However, the relationship between earnings and cash flow at GE is one that analysts are watching very closely. Simply put, in 2018 GE will be implementing an accounting standard update, namely ASU 2014-09, which relates to revenue recognition from contracts. While, it might not impact revenue over time it could impact the timing of GE's revenue and earnings recognition. This can be a concern because it's possible that GE's recent revenue and earnings might need to be restated--not good news for investors who just focus on revenue and earnings when valuing stocks.
Moreover, when GE reported a cash flow shortfall of $1 billion in the first quarter--with $300 million of it from contract assets--it highlighted the fact that GE has been booking revenue and earnings which haven't been dropping through into cash flow as yet.
Where Immelt and Bornstein went wrong
To be fair, some of the problems aren't entirely GE management's fault. For example, there is little GE can do about the ongoing overcapacity in the power market -- something that key rival Siemens has been very vocal about. In fact, GE's move to consolidate the market by buying Alstom's energy assets is a positive step. Moreover, GE's H-turbine has been a big success even as it faces increasing competition from Siemens.
While GE deserves credit for dealing in a difficult power market, management just hasn't done a good job with guidance. In fact, it increasingly looks as if Immelt and Bornstein have been too optimistic in their earnings assumptions. That's of concern because all investors have to do is look at how other industrial companies, such as Honeywell International and Caterpillar, have been conservative in their guidance.
Will GE reset expectations?
In this context, it's not hard to see that Flannery's first significant act could be to formally lower guidance and reset investor expectations. If this is going to happen, then Bornstein's departure could signal a determination to make a clean sweep and restore credibility for the new earnings targets.
In doing so, Flannery could create a positive catalyst for the stock price, because GE does have some underlying growth prospects -- not least being the opportunity to generate earnings growth through structural and product cost cuts. Moreover, Flannery could divest the healthcare business.
Where next for GE?
Investors have been prepared for some operational changes at GE, and it looks likely that they're going to get them. Cautious investors will obviously want to wait until November see what the results of Flannery's portfolio review are going to be, and Bornstein's exit is probably a signal of some significant changes to come.
All told, if you're thinking about making a long-term investment in the company, it probably makes sense to wait until the review is over and you know exactly what Flannery has planned.
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