As shares of General Electric Company (NYSE:GE) have plunged, the calls for a breakup have grown louder. Bulls see the true value of GE stock as clouded by issues at GE Capital and weakness in divisions such as Lighting and Transportation. With two still-growing businesses — Aviation and Healthcare — plus a 62.5% stake in Baker Hughes a GE Co (NYSE:BHGE), optimists argue there has to be some value in General Electric stock, particularly after a 50%-plus decline from 2016 highs.
The problem for GE stock, however, is two-fold. First, a breakup may be much more difficult in practice than in theory. A high level of corporate costs, an underfunded pension and even tax issues all could thwart any desire to split up GE’s operations.
But secondly, and more importantly, the numbers for GE stock don’t work much better in a breakup than they do at a current price near $15. Even considering the health of the two better businesses, when accounting for debt and pension expenses, General Electric looks to be valued about right.
In fact, it takes aggressive assumptions to model upside in a breakup when considering the value of each segment. And that likely means GE stock is going to have to find another way to finally start creating value for shareholders.
(Please note: segment EBITDA calculations come from the company’s 10-K’s, adding depreciation and amortization back to the company’s figure of segment profit. Figures and multiples assigned to other stocks are based on author’s calculations using original data from the companies themselves — not data from public sources.)
GE Power
The Power division has been one of the biggest problems for General Electric of late. CEO John Flannery has said publicly that the division has not been run well, and it’s hard to argue. GE was overly optimistic towards what looks like it could be a declining market, building out its capacity and its workforce while demand withered. The 2015 acquisition of Alstom for $10 billion-plus has been a disaster. Adding insult to injury, as James Brumley pointed out this week, GE had to pay Alstom another $3 billion-plus to buy it out of three joint ventures.
GE has managed to shrink the business somewhat, selling its Water business for $3.1 billion and its Industrial Solutions unit for $2.6 billion. But the long-term outlook looks bleak. GE owns about half of the market, per the 10-K – and a big share of a shrinking market is a good way to get into trouble.
Indeed, segment revenue dropped 2% in 2017. But earnings fell a whopping 28% even excluding an inventory writedown, as overcapacity led to lower prices. A 29% decline in orders in Q1 shows further demand weakness. Even with aggressive cost-cutting, including layoffs, profit in the quarter dropped 38% year-over-year.
The business might not be quite as bad as it looks at the moment. There is hope for some sort of cyclical boost in demand starting in 2019. Still, the long-term looks negative. The shift to renewable energy sources will hit long-term demand. Rival Siemens AG (ADR) (OTCMKTS:SIEGY) recently cut thousands of jobs itself, an admission that demand isn’t coming back. Figures from that company show the number of gas turbines installed worldwide has been cut in half.
Power is still profitable, generating about $4 billion in EBITDA over the past four quarters. But the multiple applied to that business likely will be fairly low. A June 2017 analysis by Credit Suisse cited a 7.3x peer multiple. Siemens trades at 10x EV/EBITDA but with a still-small contribution from Power to its overall business. Mitsubishi Heavy Industries Ltd. (OTCMKTS:MHVYF), which has a larger exposure to turbines, trades at about 7x its fiscal 2019 (ending March) forecast.
Given that GE paid 7.9x EBITDA for Alstom — and most certainly would not do so again — any multiple above 8x looks tough to support. A reasonable range for the value of the Power segment, then, looks to be $20 billion-$30 billion — assuming a 6x-7x multiple on $3 billion-$4 billion in 2018 EBITDA.
GE Renewable Energy
GE is reclaiming a small portion of its losses in Power through its Renewable Energy business. The segment manufactures wind turbines, and now blades, thanks to last year’s acquisition of LM Wind Power for $1.7 billion, along with a small hydroelectric business.
The segment isn’t a big part of GE — at least not yet. Revenue is just over $10 billion, about 9% of GE’s industrial total. 2017 profit margins were lower here than in any other business save Lighting; Renewable Energy only generates about 5% of total profit.
Size aside, however, this seems like an attractive business. Revenue grew 14% in 2017, and over 10% on an organic basis. That followed 20%-plus growth the year before, even excluding help from Alstom’s operations in the space. Q1 was a bit soft, with revenue down 7%, but the outlook looks solid, and orders grew a solid 15%, per the Q1 conference call. Margins have inched up over time — there’s a multiyear path for the business to become a solid profit grower.
But there are concerns, particularly in the wind turbine space. Stocks in the sector have performed rather poorly of late. Vestas Wind Sys/ADR (OTCMKTS:VWDRY), Siemens Gamesa Renewable Energy SA (OTCMKTS:GCTAF) and Nordex (OTCMKTS:NRDXF) all have traded down over the past year. Long-term demand is growing, but an end to subsidies and pricing pressure (which GE has cited as well) portend a risk to already-thin margins.
Even with a better performance so far in 2018, the space still looks rather cheap. Vestas trades at under 9x EBITDA; smaller players trade as low as 5x. GE’s Renewable Energy segment has posted EBITDA right at $1 billion over the past four quarters. A 10x multiple looks like a stretch, but possible, given a No. 2 share behind Vestas and potentially some benefit from a lawsuit against that rival. Renewable Energy then is worth somewhere in the range of $10 billion in a reasonably aggressive scenario.
GE Oil & Gas
The simplest way to value GE’s O&G business is to use the value of its stake in BHGE — worth about $26 billion as of this writing. Bulls might argue that the value is too low, given rising crude prices. That said, BHGE already has rallied 40%-plus since early February, in large part due to the optimism toward its sector.
A more interesting argument is whether the value of GE’s stake is lower than its market value. After all, GE would have trouble monetizing the stake if it wanted to. It would take years to unload the remaining shares into the open market — and that $26 billion worth of supply no doubt would suppress the BHGE price. Spinning off the rest of BHGE likely would send the stock down, at least in the short-term.
Flannery has sounded open to alternatives for BHGE, speculating on the November investor update call that there could be a “different form or structure for the ownership of that asset”. But I’m not sure General Electric necessarily has an attractive option.
A sale is pretty much out. Baker Hughes tried to merge with Halliburton Company (NYSE:HAL) back in 2016, but abandoned the deal due to antitrust concerns. The only other potential buyer in the space is Schlumberger Limited (NYSE:SLB) — which is even larger than Halliburton and thus more likely to raise FTC concerns. A go-private is highly unlikely, given the size of the company, the fact that BHGE already has some debt assigned to it and the cyclical nature of the space.
For now, we can assign a $26 billion value to the oil and gas business. In practice, however, GE may not be able to drive that kind of value. And any investors believing Baker Hughes is undervalued are much better off just buying BHGE.
GE Aviation
Aviation is the one business that even General Electric stock bears have to admit has real value. The commercial aviation industry is booming, as witnessed by the huge gains at Boeing Co (NYSE:BA). GE has posted nice results of late, growing revenue 4.2% in 2017 on top of a 6.5% rise the year before. Profit margins have expanded 100 bps each year as well.
The LEAP engine, manufactured by a GE joint venture, saw unit sales rise 500% in 2017. And while its ramp may hit margins in the near-term, it positions GE well for the multi-year order books at both Boeing and rival Airbus Group (OTCMKTS:EADSY). Long-term demand seems likely to only grow as passenger travel demand continues.
GE’s military business is contributing as well, with the company forecasting growth this year amid key procurement decisions in helicopter engines. And a 7% rise in revenue – plus a 26% increase in profit – in the first quarter sets the segment up well for 2018.
Any bull case for GE has to rest at least in part on the Aviation segment, which this year could generate as much as 40% of total earnings. If GE can somehow get rid of the dead wood elsewhere in its portfolio — and/or get a business like Power stabilized — the growth and profits from Aviation (and to a lesser extent Healthcare) can start to shine through.
So what is Aviation worth? Quite a bit, by any measure. MTU Aero Engines AG (OTCMKTS:MTUAF) trades at 12x EBITDA. United Technologies Corporation (NYSE:UTX) isn’t a perfect comparison, but its Pratt & Whitney unit competes with GE. (Ironically, it, like GE stock, has investors calling for a breakup as well.) It trades at about 11x and it’s acquiring parts manufacturer Rockwell Collins, Inc. (NYSE:COL) for about 14x 2018 EBITDA. Hedge fund manager Dan Loeb of Third Point LLC has argued that in a UTX split, the Pratt & Whitney-Rockwell combination would be valued at 13x (assuming a bit of a turnaround at Pratt & Whitney, where earnings have been depressed of late).
It’s not impossible to argue for a 12x-13x multiple for Aviation – which has generated $8 billion in EBITDA over the past four quarters. (Even Rolls-Royce Holding PLC (ADR) (OTCMKTS:RYCEY) trades at around 11x, with a struggling Power Systems division of its own.) That in turn would value the Aviation business alone at $100 billion.
Bear in mind that at $15, GE has a market capitalization of just $130 billion.
GE Healthcare
GE has an interesting opportunity with the Healthcare business. While some investors would like to see a spin-off of Power or Transportation, both businesses have significant problems — and concerning outlooks. Healthcare has quietly performed rather nicely. (It’s not a coincidence that Flannery was promoted from that division.) And so it might be the most attractive asset to be divested.
Indeed, the Healthcare segment grew revenue 4.4% a year ago, after a 3.7% increase in 2016. Longer-term trends aren’t quite as positive — sales were basically flat between 2013 and 2016 — but currency played a role on that front. Margins have ticked up nicely, rising from 16.7% in 2013 to 18% in 2017.
It’s not a sexy business, necessarily. But it seems like a good business, at least. And that’s not the case across the board for General Electric. That said, there are some reasons for caution here as well.
Most notably, pricing pressure in the systems business is ongoing, per the 10-K. Analogic Corporation (NASDAQ:ALOG), which competes with GE in ultrasound, sold itself last month for under its trading price in part because it feared it couldn’t compete in that industry. The healthcare space across the board – from distribution to pharmaceuticals — is struggling, and so are stocks in the sector.
That said, GE is doing just fine so far, with its own margins at a multiyear high. GE does have a life sciences business, which is growing nicely and could argue for a higher multiple. Melius Research, who has argued for 25%-plus upside in GE stock, wrote in March that another spinoff showed just how high. In February, Siemens floated a stake in its healthcare business: Siemens Healthineers (OTCMKTS:SMMNY). Melius has said the valuation assigned that stock suggests a value of $48 billion-$57 billion for GE Healthcare.
Given trailing-12-month EBITDA of $4.3 billion, that suggests an 11x-13x multiple –which seems a touch aggressive. That is using valuations more in line with Thermo Fisher Scientific Inc. (NYSE:TMO) and Danaher Corporation (NYSE:DHR), which have heavier life sciences exposure. And Healthineers has less share in the more difficult U.S. market than does GE.
Still, something in the 10x EBITDA range seems relatively reasonable, if not a bit conservative — and that suggests a standalone GE Healthcare would be worth $40 billion -$45 billion.
GE Transportation
Weak locomotive demand has sent GE’s Transportation business stumbling. Revenue fell 10.6% in 2017 after a 21% drop in 2016. Admittedly, the year-prior fall was due in part to the divestiture of the company’s signaling business. Still, the trend is clearly headed the wrong way. Cost savings led profit to rise in Q1, but revenue still fell 11% year-over-year.
The questions are whether this business can be turned around – and whether GE should be the company to do it. Weak mining demand has been a major factor. But even with President Donald Trump looking to boost the coal industry, long-term usage is likely to decline. Rail shipments of crude have fallen sharply as well, thanks to new pipelines.
The Wall Street Journal reported last month that GE was seriously considering a spin-off or some sort of hybrid deal. With EBITDA right at $1 billion over the last few months, Bank of America Corp (NYSE:BAC) unit Merrill Lynch has valued the business at $7 billion — and that seems about right, give or take a billion. Whether GE can monetize that value remains to be seen.
GE Lighting
GE is planning to exit the Lighting business, where revenue has fallen sharply since the company divested its appliance business back in 2016. Total assets appear to be in the $1 billion range, according to the recent 10-K. One estimate has valued the unit at $600 million-$800 million. Against revenue of $2 billion, that might seem low — but operating profit was just $93 million in 2017, and this remains a declining business, as the shift to LED pressures demand. A $1 billion valuation for Lighting might even be a bit aggressive.
Either way, against a $130 billion market cap, the Lighting business at this point is just a rounding error. (That’s quite a statement, given that General Electric can be traced back to Thomas Edison.)
GE Capital
GE has spent years now trying to shrink the GE Capital business built out by former CEO Jack Welch. It has sold assets and spun off Synchrony Financial (NYSE:SYF), among other efforts. The unit has shed $200 billion in assets over the past four years alone.
But GE Capital remains a problem for GE stock. The reinsurance business had to take a $6.2 billion charge in Q4. It also has to add $15 billion in funding over the next six years to satisfy regulatory requirements. That news sent General Electric stock falling yet again – and led investors to wonder what other surprises were in store.
That’s not the only issue. GE had to take a $1.5 billion charge last year for funding related to PPAs (Power Purchase Agreements) in the Renewable Energy segment. Bear in mind that business made less than $1 billion in operating profit. It adds to the idea that GE Capital has allowed GE to take risks it shouldn’t in many of its operating businesses. And it cements the concern that many investors have surrounding GE’s accounting. (Of late, GE’s free cash flow has badly lagged its net income. That should continue in 2018. The company is guiding for $6 billion-$7 billion in free cash flow — but roughly $9 billion in earnings.)
So what is GE Capital worth? At this point, some holders of GE stock would likely prefer it would just go away. Still, there is some value. Even a bearish analyst at Cowen & Co. valued GE Capital at $2.41 per share, or about $21 billion. Another analyst has carried GE Capital at book value – about $14 billion at the end of 2017.
All told, something in the range of $15 billion-$20 billion seems reasonable (1x-1.5x book value). Conservative investors couldn’t be blamed for valuing the business at zero, however, given the possibility of more concerns popping up.
The SOTP for General Electric Stock
On a sum of the parts basis, then, GE stock looks something like this:
Power: $20 billion-$30 billion
Renewable Energy: $10 billion
Oil & Gas: $26 billion
Aviation: $100 billion
Healthcare: $40 billion-$45 billion
Transportation: $7 billion-$8 billion
Lighting: $1 billion
GE Capital: $15 billion-20 billion
That supports a total value of about $219 billion on the low end and $240 billion on the high end. That sounds awfully attractive compared to the company’s $130 billion market cap.
But investors have to remember that GE has liabilities — and there are more issues, too.
GE’s Liabilities
On the industrial side, GE closed Q1 with net debt of $63.7 billion. (GE Capital’s liabilities are deducted from the calculation of book value. To include them here would be double-counting.) But there’s also a pension liability of about $34 billion.
The SOTP valuation doesn’t account for either debt or the pension obligation. Backing out the combined $97.7 billion from the $219 billion-$240 billion enterprise value suggested so far implies a market cap of $121 million-$142 million. The end of Q1 share count was 8.696 billion, according to the 10-Q. So this method — again, accounting for the liabilities — suggests General Electric stock is worth between $14 and $16.40 per share.
With GE stock trading just below $15, that range would argue that the market has it about right. But there’s one more fundamental factor that needs to be considered. GE also has corporate costs that it doesn’t allocate to its segments — which totaled $5.5 billion in 2017. Those costs need to be accounted for.
Apply even an 8x multiple to those costs and GE stock in theory would be worth as little as $9-$11 — at least based on the numbers seen so far. Similarly, assigning those costs to each unit based on revenue would depress the profits from — and the valuation of — each individual business unit. For instance, Healthcare might have generated $4.3 billion in EBITDA under GE’s ownership; its profits would decline on its own, as some of the costs now borne by GE corporate would hit its P&L.
When considering the whole of General Electric, a sum of the parts analysis suggests the stock still is overvalued. And that alone is a solid argument against a breakup.
Can GE Stock Be Worth More?
All that said, those numbers aren’t set in stone. The pension liability, for instance, is an accounting issue — and it can be calculated different ways. ERISA accounting says the pension is 94% funded, not 74% — in which case GE’s “actual” pension liability drops by about $25 billion, adding almost $3 per share.
The Power business, in this model, could be significantly undervalued. That’s particularly true if GE can execute a turnaround. The business is on track for $3 billion-$3.5 billion in 2018 compared to $5 billion in 2016. Simply returning that business to profit levels of the past few years would imply at a more market-average 9x-10x multiple. That in turn suggests a valuation of $45 billion-$50 billion instead of $20 billion-30 billion. Here, too, GE stock gets another roughly $3 per share.
Renewable Energy could be worth more than $10 billion if GE consolidates market share in wind. Moving Healthcare up from this model’s $40 billion-$45 billion to Melius’ roughly $50 billion-plus adds $1 per share.
But even making all those moves still suggests that General Electric stock maybe, in a very bullish scenario, is worth $18. More importantly, it shows the folly of arguing that a breakup will solve GE’s problems — or send GE stock notably higher.
The Problems With a Breakup
GE has said it wants to divest about $20 billion in assets over the next two years. That likely includes Transportation, plus a small divestiture in the Healthcare business in the first quarter, and other smaller moves.
That’s not enough to move the needle. It’s not even 10% of General Electric’s enterprise value. It doesn’t fund the pension. (GE actually is borrowing another $6 billion this year to make contributions to the plan. It believes it won’t have to do so in 2019, however, according to the 10-K.) It would cut debt — but it won’t make GE debt-free.
More broadly, there’s two paths GE can take. The first, which appears more likely from Flannery’s recent comments, is that it reorients around Healthcare, Aviation, Power and Renewable Energy. In that case, there’s not enough value in the remaining businesses to really change the financial situation. GE still is reliant on the Aviation business staying strong, Healthcare competing well and driving a turnaround in Power.
The second involves a more aggressive move. Either a massive split into three or four separate companies, or a spinoff/sale of Healthcare or Aviation. After all, those are the businesses with real value. But the pension, in particular, creates a significant complication. Losing one of the two good businesses — even assuming that some level of debt and pension expense go out the door as well — puts a lot of pressure on the smaller GE to cover those obligations.
Assume, for instance, that GE could get $100 billion, in cash, for the Aviation business. That sounds like a great deal given that the figure is about three-quarters of the current market cap. GE could clear its balance sheet and its pension liability in one fell swoop. But what’s left is a company still worth about $130 billion – with only about $12 billion in EBITDA. That in turn, given around $3 billion in capex is expected in 2019, suggests something like $5 billion-$6 billion in free cash flow after taxes — a multiple over 20x for a GE that still has struggling businesses in Power and Transportation.
There’s also the question of how much tax GE might have to pay in such a move. Note that it booked a $1.9 billion gain on its $3.1 billion sale of the water business — and those gains are taxable. Depending on how the various businesses are carried on the books, a sale of a performing unit could incur substantial tax liabilities and on its own destroy much, if not all, of the value it’s supposed to create.
A Breakup Doesn’t Fix GE Stock
The problem for GE stock, in a nutshell, is that it can’t sell its good businesses, and its bad businesses don’t make enough of a difference. The only way out is for its bad businesses — specifically Power and Transportation — to improve.
In other words, GE is going to have be a turnaround play. Flannery can make some moves around the edges to help on that front. Divesting Transportation may make sense, instead of throwing good money after bad. An exit from BHGE, if the company can find a way, could bring in cash that would clean up the balance sheet. But the idea that there’s a path to major upside is far too optimistic. It’s very difficult to argue that GE stock is worth $20 in a breakup scenario — and that’s ignoring the difficulty of such an endeavor and the potential tax complications.
Of course, it’s hard to argue that GE, as a standalone, is worth $20. The stock trades at almost 15x the midpoint of 2018 EPS guidance, which analysts don’t even trust. (Guidance is at 94 cents, against the range of $1-$1.07.) More to the point, given the questions surrounding GE Capital and its accounting, it trades at 20x free cash flow.
That’s a big multiple. It’s a multiple that suggests GE will get back to being what it was. And that in turn requires that the lagging businesses stop being drags — and start providing growth. That’s the only way out for General Electric. Its businesses have to get better — unless it can find someone willing to pay an enormous premium to try and fix them.
That seems like an awful lot to ask.
As of this writing, Vince Martin has no positions in any securities mentioned.
