Description

General Electric (GE)

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Elevator Pitch:

·         GE is a Long.  A series of significant catalysts including two announced spin offs will occur over the next two years and drive GE’s share price towards my price target. 

·         Investors have largely shrugged off the news that GE is set to increase shareholder value by breaking itself up into three pieces.  In the interim, GE’s share price will largely be dictated by a recovery in the Aviation industry, which has already begun as air traffic picks up as vaccines are distributed globally. 

·         Target Price: Using a Sum of the Parts analysis, I estimate GE is worth $118 (+28%) in a Base Case and $139 (+51%) in a Bull Case.  The potential for shareholder value creation is so significant that even my Bear Case shows small downside at just $90 (-2%).  

Current Situation – The Consensus View on GE:

GE has historically been a complicated story with numerous divisions operating across multiple industries, all backed by a monster balance sheet that even the best financial investors had problems analyzing.  GE’s management took a huge step towards clarifying the investment story on November 9 when they announced their plan to break GE into three pieces via two spin offs.  GE’s conglomerate structure only worked when Capital was the hub, operating effectively as a bank to finance each division as it saw fit.  With the wind-down and sale of Capital’s major assets, the conglomerate model no longer makes much sense.  The simplification of GE’s story combined with creation of three independent and focused companies are catalysts for a re-rating over the next two years.

The Consensus View on GE before November 9 2021 had been that the stock was cheap, the conglomerate difficult to analyze, but ultimately the company’s medium-term fate was tied to a recovery in the Aviation industry.  The Consensus View today is that GE just began a two year journey to unlock shareholder value via several corporate actions and there is no hurry to get involved given the elongated timeframe for the breakup.  This ‘meh’ reaction from investors is evident in the fact that GE’s stock went up just 2.6% the day of the spin off announcement and today sits about 107% lower than that post-announcement high.

Many investors currently argue that GE’s stock is in ‘deal purgatory’ as the first spin off is not expected to happen for at least one year.  They likely look at how the shares of United Technologies (UTX) traded sideways after they announced the dual spin of Carrier (CARR) and Otis (OTIS).  DuPont/Dow’s (DD/DOW) merger/break-up had similar trading characteristics.  Many GE investors, including special situations traders, are likely asking themselves ‘why buy now?’ when the major catalysts are still so far away.

To illustrate this view, GE is currently trading at 9.3x EV/EBITDA on 2023 estimates.  Nothing in Aviation or amongst GE’s Multi-Industrial peers trade this cheaply (see peer multiples later in this piece).  Similarly, GE is trading at 14.5x the low end of management’s 2023 FCF guidance (>$7B).  Again, nothing in Aviation is this cheap and MMM trades this cheap and is a low single digit grower.  Taken together, I think it’s safe to say that investors are currently valuing GE much the way they always have: as a low margin conglomerate with few high value assets.  This view will change significantly over the next two years.

Future Timeline & Catalysts:

Over the short to medium term, GE’s stock is going to be dominated by Covid and air travel-related headlines as the crown jewel of the business is the Aviation segment which generates about half of the company’s 2023E EBITDA and was hit the hardest by Covid-related declines in air travel.

Over the medium to long term, GE’s stock will be impacted by corporate action-related headlines related to the two spin offs, a few asset divestitures and future capital return plans.

Short Term (<6 Months)

Covid Case Data: In the short term, GE’s stock is tied to forward-looking indicators of air travel and the biggest swing factor for travel sentiment is Covid Case Data.  Unfortunately for GE, Covid cases have begun to rebound post-delta surge in both the US and Europe (see charts below).  I do not think we should be surprised if we have another winter surge of Covid given the history of coronaviruses during the cold season.  Luckily for investors we get this data daily and it’s all headed in the right direction

Air Travel & Plane Sales Data: Air travel has been recovering slowly ever since bottoming out in the Spring of 2020 due to Covid.   Commercial flights globally have recovered nicely although the path back to 2019 normalized levels appears to have stalled the past few months and the 7-day moving average for flights currently resides at ~78% of 2019 levels. 

Source: https://www.flightradar24.com/data/statistics

Ultimately for GE, flights need to translate into plane shop visits as well as new plane (and engine) orders.  Bernstein expects Airbus and Boeing plane delivery totals to reach 2018 levels sometime in the 2023-2024 timeframe.  This will be a lengthy recovery.

Medium Term (6 Months-2 Years)

Spin Off #1: Healthcare: First, expect a Form 10 filing with pro forma financials for Healthcare either in Q422 or Q123, about 3 months before the spin.  Second, the spin will most likely occur in Q123.  After that, expect management to host an Investor Day to lay out their long-term operating model and capital allocation plans.  Also, expect GE Healthcare to get added to the S&P 500 upon rebalance as it will likely have a market cap upwards of $50B.  Finally, this spin off is important to GE’s deleveraging story as Healthcare is the business unit most capable of taking on significant leverage (>3x most likely).  If Healthcare were to take on 3.25x turns of leverage upon spin it would reduce leverage at the Parent by $14B and take Parent leverage below 1.0x on 2023E estimates. 

Spin Off #2: Renewable Energy & Power: First, expect a Form 10 filing with pro forma financials for Renewable Energy & Power either in Q423 or Q124, about 3 months before the spin.  Second, the spin will most likely occur in Q124.  After that, expect management to host an Investor Day to lay out their long-term operating model and capital allocation plans.  Also, expect this new company to get added to the S&P 500 upon rebalance as it will likely have a market cap upwards of $15B.  Finally, if this unit has successfully divested itself of most of its coal-adjacent assets by the time of the spin, expect it to get a lot of attention from ESG investors.  The scarcity value of a wind turbine maker may raise the valuation of this asset higher than most investors currently imagine.  Expect this asset to be added to several ESG indices upon spin as well.

Public Equity Stake Sales: GE owns sizable stakes in two publicly traded companies.  Investors want to see GE liquidate these stakes to reduce leverage and simplify the story.  Expect these stakes to be fully liquidated by the time the second spin is completed in early 2024. 

·         Baker Hughes (BKR) Stake Sales: GE has been selling off its stake in BKR ever since the combination of GE's oil and gas assets with BKR was consummated in July 2017.  Expect a full exit within the next year. 

·         AerCap (AER) Stake Sales: GE just consummated the merger of GECAS with AER on 11/1/21.  GE now owns 45.5% of AER ($6.9B) that is subject to lock-ups.  One third of the shares are locked up for 9 months (expect a block sale in Summer 2022 after 8/1), one third are locked up for 12 months (window opens 11/1/22) and the last third are locked up for 15 months (window opens 2/1/23 right around the time of the Healthcare spin). 

Leverage Target Reached: GE’s management has guided to a target of <2.5x net debt/EBITDA by 2023.  But GE uses a methodology unlike its multi-industrial peers utilizing a ‘rating agency method’ that is non-standard and arguably punitive as it includes as debt the unfunded pension, operating lease liabilities and preferred stock.  Expect GE’s industry standard leverage to be <1.5x by 2023 as a result of asset sales and EBITDA growth which will open up their investment story to a much larger universe of investors. 

Long-Term Care (LTC) Sale: GE’s Head of IR has been telling investors recently that management is actively looking to sell the LTC business to put this issue behind the company.  At the very least, they expect to have this overhang completely off their Balance Sheet by the time the second spin is completed in 2024.  Background: GE’s stock took a massive nosedive in 2017-2018 largely because the company’s Long-Term Care insurance portfolio blew up.  Their actuaries mis-estimated how much long-term care would cost for their policyholders as well as how long they would live.  While the LTC issues are now well known by investors, the remaining reserve liability is subject to annual valuation testing and is currently about $5.5B in size.  But, GE may need to ‘pay’ an external buyer a few billion dollars to take this albatross off of their Balance Sheet.  Either way, getting this LTC liability away from GE will remove a massive overhang on the stock.

Long Term (>2 Years)

Healthcare 19.9% Stake Divestiture: After the Power & Renewable Energy spin, GE Aviation will be standalone but current plans call for Aviation to hang onto a 19.9% stake in GE Healthcare.  Management likely decided to keep this stake to increase capital flexibility at Aviation as the core business will (possibly) be saddled with the LTC Liabilities.  Additionally, while the aerospace industry is returning to normal after Covid at a measured pace, management does not know with certainty that this division’s profitability will be fully recovered two years from now.  They want to hold onto the 19.9% stake in Healthcare, the unit that can be levered up the highest, so that they can raise capital at GE Aviation if needed.  Expect this stake to be divested within two years post-spin.

Dividend Reinstatement: Yes, GE technically has a dividend ($0.08 quarterly or a 30 bps yield), but they only kept it above zero when they slashed it over 90% in 2018 so that yield investors would not be forced to puke the stock completely.  Expect GE Aviation to reinstate a meaningful dividend once leverage gets in line with multi-industrial peers below 1.5x.  This will occur after the final spin.  GE Healthcare too is likely to start a dividend post-spin.

Potential Corporate Actions: I would not be surprised to see one or two of GE’s pieces either be a consolidator in its industry or get consolidated itself.  Perhaps a large medtech company wants access to the steady cash flows of GE’s radiology business.  Or perhaps GE Aviation wants more exposure to the military market.  These two spins will likely not be the last major corporate actions for GE over the next several years.

Event Risks:

GE Backtracks:  The spin off plan is either cancelled or delayed by management/Board.  This would likely only be precipitated by some sort of Balance Sheet problem where they would need to keep the segments together to support the entire enterprise.

Market Downturn:  A sizable decline in the S&P 500 hurts the value of GE’s equity stakes in BKR and AER and may increase the liabilities associated with both the Unfunded Pension and the Long-Term Care liabilities.   Additionally, a decline in the market value of GE’s peers lowers the target price for any investor using a Sum of the Parts valuation model. 

Covid Resurgence: The biggest swing factor in EBITDA over the next three years is a recovery in the Aviation segment.  A resurgence in Covid leading to less flight activity on a global basis will delay this normalization in profitability. 

Inflation Accelerates: GE manufactures big, complicated machines that depend on a global supply chain that is costly to maintain and subject to raw material price increases.  GE may not be able to increase prices or renegotiate contracts sufficiently to offset inflationary pressures if they continue to accelerate. 

Liabilities Underestimated: GE Capital is still a black hole of debt residing on the company’s balance sheet.  There have been numerous liability surprises that have been dredged up by management the past few years and the possibility always exists that some other debt bomb will go off in the future.  Either way, I functionally value GE Capital at -$6B in my SOTP; I do not ascribe it a positive value. 

Sum of the Parts Valuation & Key Variables:

Peer Multiples: By far the biggest swing factors in my Sum of the Parts Valuation analysis are the EV/EBITDA multiples used to value each segment.  To begin, let me note that GE looks cheap when compared with its Multi-Industrial Peers but perhaps not too unfairly given that it has the lowest consolidated EBITDA margin amongst its direct peer set.  But, GE’s Aviation segment is currently under-earning due to Covid and the Renewable Energy business is generating cyclically depressed EBITDA.  Investors must value GE on a SOTP in order to ascertain fair value – especially in light of the pending spin offs. 

GE Comps: (Data is from Bloomberg. All financial data is in local currency.)

For all four segments my Base Case EV/EBITDA multiple is based upon the Median of the peer set I provided above.  I expect this is how most investors will value GE because this is how investors valued similar break-up scenarios at UTX, DD, and HON.  There are no perfect comps for GE’s segments, and many of them are Europe-based, but the list above offers investors a sufficient comp set to value GE’s three future standalone companies.  Additionally, in the Bear Case I have utilized the lowest valued peer for Healthcare, Renewable Energy & Power in a conservative effort to value a downside case – and even then I get a target price within striking distance of today’s share price. 

·         Aviation: The trio of RTX, SAF.FP and MTU.GY all trade in a very tight EV/EBITDA range.  I do not see why GE’s Aviation business will not trade close to these three if GE’s EBITDA margins are marching back towards their historical levels in the low 20’s.  In fact, one could argue that GE Aviation should trade at the biggest multiple in the set if their historical margins are recaptured. 

·         Healthcare: There is a big range between where Siemens Healthineers and Philips trades because of Philips’ lower historical growth rate as well as some recent execution issues in their Sleep business.  GE has EBITDA margins higher than both of these peers and I think a median multiple between the two is appropriate in the Base Case. 

·         Renewable Energy: This segment is tough to value because earnings are currently depressed due to a cyclical downshift as well as rising inflationary cost pressures.  Both peers, Siemens Gamesa and Vestas Wind, trade at sizable multiples due to scarcity value, high ESG ratings and a potential for sales acceleration as the world moves further into renewables.  Again, I believe that a median multiple between the two is appropriate for GE if we assume that EBITDA margins will start to recover in 2022 and beyond.

·         Power: There is a big range between where Siemens Energy and Wartsila trade due to higher margins at the latter as well as Siemens’ historical ties to ‘dirty’ energy.  GE still has some coal assets they need to wind down and their margins are likely in between those of Siemens and Wartsila.  A median multiple between the two is appropriate in the Base Case.

APPENDIX:

Management:

Insider Buying/Selling & Stock Ownership

There are no transactions of note that occurred in 2021 although it was nice to see CEO Larry Culp buy $5m worth of stock in 2019 at prices ranging from $63 to $72.

Collectively, the Board and Executive Management own a decent amount of stock.  The Board owns ~$57m worth (excluding Ed Garden’s Trian shares) and Executive Management ~$400m, dominated by CEO Larry Culp. (This table is from the May 2021 proxy and all figures must be divided by 8 to account for the July 1-for-8 reverse stock split). 

Cash Bonuses:  Annual cash bonuses are pretty typical and focus management on operating metrics that they can control: FCF, EBIT Margin expansion and Organic Revenue Growth.

Long-Term Compensation: I like this one as management is incentivized to generate Total Shareholder Returns in excess of their direct peers (via the S&P 500 Industrial Index).   It would be better if their target bonus was set at a higher percentile than 55th. 

Culp got paid handsomely in 2020 after receiving a well-timed ‘Leadership Performance Share Award’ that paid out much faster than the Board was likely anticipating because the stock traded above $104 ($13.34 x 8) for 30 consecutive days earlier this year.   Larry easily cleared over $100m from this grant in about one year. 

Leadership Performance Share Award:

Management is well-compensated which should come as no surprise given this is an old school, large industrial corporation.  Some might characterize it as egregious although Larry Culp is generally considered to be one of the best managers in the industry.

Tidbits:

●        Sell Side: GE is favorably viewed by the Sell Side and enjoys 17 Buys, 7 Holds and 0 Sells with an average Target Price of $114 (+24%).  There is only one real bear, JP Morgan, who has a $55.00 target (but oddly only a Neutral rating). 

●        Short Interest: GE is not a heavily shorted stock with just 1% of the float short and 1.7 days to cover. 

DISCLAIMER:  This is not a recommendation to buy or sell any investment.  Additionally, this document should not be relied upon to make an investment decision as the numbers and figures presented are solely the author’s estimates.  Investors should contact the company directly and read GE public filings to form their own opinions and make their own investment decisions.  The author may transact in the securities of GE without notice.  

Catalyst

Spin Off #1: Healthcare (Q422/Q123)

Spin Off #2 Renewable Energy & Power (Q423/Q124)