Recovery Thesis Strained at GE - TheStreet

Recovery Thesis Strained at GE

Revenue is flat, while power systems and plastics drag down earnings.
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(Editor's note: General Electric is probably the economy's single-best corporate proxy. That's why it's in 21, a new index of 21 companies designed to be a leading indicator of the economy's direction for the rest of the year and beyond. Here's a look at its earnings, reported earlier today. Click here for an introduction to the 21, and click here for a chart listing the components and their reason for inclusion.)

Investors looking to

General Electric

(GE) - Get Report

for evidence of a turnaround in the economy were sorely disappointed Friday.

As expected, the Fairfield, Conn.-based company narrowed the range of its profit estimates, saying it now expects to earn between $1.55 to $1.61 a share this year, down from a previous range of $1.55 to $1.70. That represents just 3% to 7% growth over 2002.

During a conference call with analysts, CEO Jeffrey Immelt said he has seen some positive developments in the marketplace, but he cautioned that economic growth remains "slow." Shares of GE have climbed 16% this year, largely on hopes that the economy would rebound strongly in the second half of the year.

"I think there's a number of good signs," Immelt said. "Interest rates remain low, the consumer remains strong, delinquencies remain in check, there's liquidity in the marketplace

and some of the uncertainty created by the war and SARS is behind us. Those things, and the stimulus package ... are all positives ... but what remains is excess capacity, and I think that's just going to take some time."

At about 74%, capacity utilization continues to be "sluggish," he said. Immelt stressed that GE has done a good job of executing in a "difficult" environment. But GE's power systems unit is continuing to unwind from the "bubble" it experienced in previous years and the plastics division is still struggling with very high raw material costs.

For the third quarter, GE expects earnings of 39 cents to 42 cents a share, compared with analysts' 42-cent estimate. The disappointing performance is due to a projected 15% drop in revenue and a 40% decline in profit at the firm's power systems unit. Earnings at the plastics division are slated to fall 40% in the third quarter. In fact, Immelt conceded that weakness at the plastics unit is perhaps the main reason that the firm cut the top end of its estimates Friday.

"We've been killed on raw materials," said Keith Sherin, chief financial officer at GE. "We've got to see a break in raw material costs" going forward.

The performance of GE's plastics unit is considered an important indicator for the broader economy because plastic is used in so many different industries. GE said its television unit NBC should be one of the stronger performers in the third quarter, and that it is projected to post a 15% to 20% increase in profits.

Despite GE's weak forecast, shares rose about 0.4% to $28.31. Some analysts said they were pleased with the tone and quality of GE's earnings in the second quarter.

There were "few surprises in the quarter and quality was solid," said Banc of America analyst Nicole Parent.

GE has come under a lot of scrutiny in recent years for carefully managing its earnings. Some analysts had accused the firm of using an unusually low tax rate to boost results in the first quarter and others complained about GE's reliance on gains from securitizations, or sales of bundled loans.

Credit Suisse First Boston analyst Michael Regan, who has called GE's earnings quality "sloppy" in the past, said the firm's tax rate this quarter was in line with his forecasts "so there seems little room to question the quality of industrials' earnings in the quarter."

GE also said during the conference call that it wouldn't rely on securitizations to boost profits as much as it had done in the past.

Still, Standard & Poor's analyst Robert Friedman reiterated his hold rating on the stock Friday, saying the chances of GE's posting consistent long-term earnings gains of 10% are "slim." Both CS First Boston and Banc of America have an investment banking relationship with GE, while S&P doesn't.

For the second quarter, GE recorded a profit of $3.79 billion, or 38 cents a share, compared with $4.43 billion, or 44 cents a share, in the year-ago quarter.

Commercial finance, consumer finance, consumer products, industrial systems, insurance, medical systems, NBC and specialty materials all had double-digit earnings growth during the quarter. However, as expected, weak sales of large gas turbines at power systems, along with lower volume and higher raw-material costs at the plastics unit, were a big drag on earnings.

Revenue totaled $33.37 billion, virtually unchanged from $33.33 billion a year ago. Sales of goods and services totaled $18.11 billion, down from $20.26 billion a year ago. GE Capital's second-quarter revenue was $15.11 billion, compared with $12.99 billion last year.

On average, analysts polled by Thomson First Call had projected earnings of 38 cents a share and revenue of $33.62 billion.

"We delivered another quarter of broad-based performance in a tough economy, with eight of our 13 businesses achieving double-digit earnings growth while we managed through the downturn in power systems' sales of large gas turbines," Immelt said in a press release. "At the same time, we made further progress on building the foundation of our future growth."

Immelt also said that the "year is turning out as planned. As expected, the ramp-down of our turbine shipments in the first half created earnings pressure. However, we are executing with broad-based strength to generate significant growth in the second half. We see nine of 13 businesses growing in double digits and more favorable comparisons in power systems and insurance."

Eight of GE's 13 businesses -- commercial finance, consumer finance, consumer products, industrial systems, insurance, medical systems, NBC and specialty materials -- had double-digit earnings growth during the quarter.