Last November, a storied industrial conglomerate General Electric (GE) has announced its intention to separate. GE plans to spin off its healthcare business in early 2023 as a new standalone company. Meanwhile, it will combine its power, renewable energy and digital businesses into a new energy-focused business and spin it off in early 2024. This will leave GE as an aviation-focused business going forward. .
This news gave GE stock a short-term boost, but the momentum did not last. In mid-December, shares of General Electric were trading near their 2021 lows, although they have since rebounded to just over $100.
In the long term, the split in pure-players aviation, healthcare and energy could potentially unlock shareholder value by tackling the problem of “conglomerate shed”. However, a less-noticed development could have a bigger impact on GE stock.
General Electric is finally wrapping up its multi-year balance sheet repair effort, tackling what has been a major drag over the past few years. With the balance sheet bogeyman firmly in the rearview mirror, GE stock is poised to generate impressive (spillover-adjusted) gains over the next few years.
Debt burden drops significantly
At the end of 2018, shortly after Larry Culp became CEO, GE had gross borrowings of around $105 billion. Through a series of asset sales, punctuated by the sale of GE’s biopharmaceutical business for net cash proceeds of $20 billion, General Electric reduced that figure to $63 billion by the end of the third quarter of 2021.
During the fourth quarter, General Electric completed what will likely be its last major divestiture, selling its GECAS aircraft leasing business to AerCap (ARE). This deal brought in immediate cash proceeds of $23 billion. GE used that money along with internally generated free cash flow and excess balance sheet cash to execute a $25 billion takeover bid last quarter.
As a result, General Electric likely ended 2021 with gross borrowings in the $37-38 billion range. In addition, GE also received 111.5 million AerCap shares and $1 billion in senior notes as part of the GECAS sale, worth a combined $8.4 billion today. By adding the value of GE’s remaining stake in hugue baker (BKR), the company holds nearly $13 billion in debt and equity securities that it can monetize over the next few years to further reduce its debt.
Offsetting these assets with the company’s remaining borrowings, GE’s pro forma long-term debt is approximately $25 billion. This is a very manageable sum given that EBITDA is expected to reach at least $12 billion by 2023 (before adjusting for health fallout).
The pension deficit is also shrinking
Debt hasn’t been the only concern of the investment community regarding GE’s balance sheet in recent years. The deficit in the company’s pension plans has also come under scrutiny.
GE’s pension deficit peaked at more than $31 billion at the end of 2016. However, as I noted in late 2019, the pension deficit was not as heavy a burden as it could have been. appear, as long-term asset returns were likely to exceed the discount rate. used to calculate GE’s pension liability.
Indeed, GE’s pension assets posted double-digit returns in 2019 and 2020, including back-to-back gains of 17% for the main US pension plan. Lower interest rates drove some of these gains, but also led to additional actuarial losses that further increased GE’s pension liabilities. This negated most of the benefit of strong asset returns. Even so, contributions to GE’s pension plan over the past few years had reduced its pension deficit to $20.6 billion by the end of 2020.
In 2021, the pension plan deficit is likely to have shrunk dramatically, despite minimal corporate contributions. First, interest rates have risen, with the 10-year Treasury yield dropping from around 0.9% to 1.5% in 2021. Higher interest rates translate into lower pension liabilities, as future benefit payments are discounted at a higher rate.
A drop of almost a percentage point in the 10-year yield in 2020 contributed to actuarial losses of $9 billion for GE’s pension plans in 2020. This suggests that the rebound in interest rates in 2021 could have led to an actuarial gain of around $5 billion, thereby reducing GE’s pension deficit.
Second, the S&P 500 had a total return of 29% last year. While rising interest rates likely devalued the fixed-income portion of GE’s pension assets, debt securities accounted for just under half of asset allocation in plans. pension from GE (on average). As a result, GE’s pension assets likely generated another year of double-digit returns in 2021, potentially reducing the pension deficit by another $5 billion.
When the numbers are finalized, I expect GE to report a year-end 2021 pension shortfall in the range of $10 billion to $12 billion, primarily attributable to GE’s unfunded supplemental pension plan for senior executives. Rising rates could further reduce this reported pension deficit in 2022, ending this long-standing investor concern once and for all.
Valuing GE as a whole
At the end of October, General Electric estimated that it would generate about $5 billion in free cash flow in 2021, taking into account the impact of stopping its factoring programs. The company expects to grow that figure to at least $7 billion in free cash flow by 2023, driven primarily by the recovery of the aviation market and the return to full health of the energy and utilities divisions. renewable energies.
Before the pandemic, industrial companies typically traded at an average free cash flow yield of around 4% (i.e. 25 times free cash flow). With its balance sheet recovery and repair effort nearing completion, GE should earn a similar assessment.
This implies that GE stock would be worth at least $160 by the end of 2023: up nearly 60% from today. If free cash flow were to exceed $7 billion by a significant margin, the stock could rise further.
Aviation is what I want to own
GE’s breakup plan gives shareholders even more long-term benefits by allowing investors to choose which part(s) of the company to invest in. While it’s impossible to know precisely how the market places value on the three future entities, I expect the aviation business to have the most benefit after the spinoffs.
GE Healthcare is a stable and highly profitable company. The segment’s annual operating profit is approaching $3 billion, and the healthcare unit has plenty of room for long-term growth. As a result, GE Healthcare will likely get a solid valuation in the $50-60 billion range, depending on how much debt it takes on. This would make the 80.1% stake distributed to GE shareholders worth about $40 per current GE share.
Electricity/renewable benefits will be less valuable. These divisions have shaky track records for profitability, the traditional electric business faces centuries-old headwinds from the energy transition, and GE expects the fallout to drive single-digit operating margins. A valuation in the $20 per share range (about $20 billion to $25 billion) seems reasonable, although some experts have higher estimates.
That leaves an implied valuation in the $40 range (or maybe $50 at most, if I overestimate valuations of other spinoffs) for GE to come. The company will primarily consist of GE Aviation, but will also include a 19.9% stake in the healthcare spin-off and various legacy assets and liabilities: notably, GE’s run-off insurance obligations.
The global aviation market will exceed pre-pandemic levels within a few years. Indeed, in some regions, demand has already fully recovered from the pandemic. As I have said before, the continued recovery will lead airlines to restore full utilization of their fleets, leading to a sharp rebound in engine service events, which generate the bulk of GE Aviation’s profits. The growth of the military aviation market will also bring additional revenue and profit.
By around 2025, New GE’s free cash flow could exceed $5 billion. With a free cash flow yield of 4%, that would imply a fair value of over $125 billion ($114 per share). Even a more conservative free cash flow yield of 5% would put its intrinsic value at a minimum of $91 per share.
Fear over the insurance industry could weigh on GE shares in the period immediately following the fallout. However, the projected profitability of the insurance business has improved over the past two years. So while investors may assume that the run-off insurance business has negative value, it likely has positive value that GE can eventually realize through a sale or phased liquidation of the company. unity.
Additionally, GE retains a 19.9% stake in the healthcare sector to provide an additional cushion against any surprises from its legacy liabilities. If such surprises don’t materialize, GE could potentially monetize that stake and return that money to shareholders or use it for aviation-related acquisitions, increasing the stock’s upside potential.
In short, GE’s balance sheet improvements will support multiple expansion in the years to come, unlocking substantial benefit for shareholders. The ability to cash out by selling health and energy spinoffs over the next two years (assuming they trade at reasonable valuations) simply amplifies the potential gains.