General Electric (GE, Financial) can be divided into seven separate businesses in its industrial segment: power and water, oil and gas, energy management, aviation, health care, transportation and lighting. The company is in the process of downsizing its finance division, and the latest news is it sold a considerable chunk of $32 billion in book value to Wells Fargo (WFC, Financial). The company wants to concentrate on the industrial segment and sell off additional parts of the remaining finance portfolio until the end of 2016.
Notably Nelson Peltz, through his Trian Fund, has taken a $2.5 billion position in General Electric. Peltz is apparently enamored with the company’s industrial businesses with lots of recurring predictable revenue streams at solid margins. Peltz is likely to pressure management, if needed, to operate even more efficiently throughout the organization and cut any unnecessary fat.
Guru Bill Ackman (Trades, Portfolio) spoke about General Electric for a short while in a recent Bloomberg interview, talking about his reasoning for refraining from investing there. He agrees with Peltz about a number of things but ultimately found the valuation too demanding to invest.
General Electric is not a natural target for activists as it is well known for its excellent operations and as a training ground for the best of the best among operational managers.
However, the company has recently acquired French company Alstom, which appears to be a more promising target to implement cost-cutting measures.
Management
I have looked at GE CEO Jeffrey Immelt's track record in depth in the past, and his performance was not terrible. At the same time it wasn’t exceptional, either. At this time I have little reason to believe he is making a huge difference in the level of returns to shareholders. In his defense, General Electric is a mammoth of a company and returns tend to diminish with size. He is swimming upstream. In the interview linked to earlier, Ackman was especially critical of the acquisitions that have been made by General Electric, which are ultimately Immelt’s responsibility. Ackman is known to be a supporter of acquisition-happy CEOs when they are executed the right way but apparently thinks the ones General Electric engaged in were value destructive. Truth is, returns on invested capital, returns on equity, returns on assets and shareholder returns have been low to nonexistent over the past 10 years.
Financial state and risk
On a positive note, Immelt has in general been running General Electric in a more defensive way compared to his predecessor. The company still got into trouble during the financial crisis thanks mainly to its financial arm. Perhaps you remember Warren Buffett (Trades, Portfolio) coming in and helping the company out? For a price of course. Now that GE is selling its financial arm to Wells Fargo its financial stability will improve a lot. Although the company is likely to become more vulnerable to the cyclicality in the industrial sector, it is much less likely to blow up through a bad loan book. Overall, I view the downsizing of the finance business as a positive and expect it will help GE to get valued more accurately.
General Electric has an enterprise value of over $500 billion. It can take a few disappointments in stride, but the Alstom acquisition was a big one and if the company encounters a lot of problems integrating it, that could put a damper on results.
The company is also susceptible to recessions and most of its large projects require long sales trajectories. A bad macro environment can derail or delay these further. It is not a risk unique to General Electric, but the company is not immune to the fluctuations in the greater economy.
Valuation
I would not rely on P/E or EV/EBITDA ratios too much as long as the finance arm is still consolidated or when comparing the company going forward with its historical valuation metrics. P/E and EV/EBITDA can easily get distorted by a finance operation. Book value metrics will work better. Currently, I think the best way to come up with a valuation for General Electric is by performing a DCF calculation. Gurufocus offers great tools to easily perform a DCF yourself, which I highly recommend. The downside of a DCF calculation is that it can yield massively different results when you adjust the inputs.
The assumptions I put into my model are that General Electric will grow earnings for at least another 10 years. I only use 10 years as a period of expanding earnings when I am fairly sure a company has a strong competitive position. General Electric qualifies because it tends to operate only in markets where it is the No. 1 or No. 2 player. That means it benefits from scale advantages. In addition, it has a history of tackling large and complicated projects successfully. Often clients spend money on these projects that they cannot, under any circumstances, gamble on an unproven operator. That gives General Electric the advantage. General Electric can also serve multinationals all over the world wherever they require its services and has lots of long-term contracts in place solidifying a recurring revenue stream. When the finance arm is sold, its overall competitive strength only increases.
I estimate a normalized figure of earnings for General Electric for 2016 is around $1.6 per share without the division sold to Wells Fargo.
The transformed General Electric should have a real shot at growing FCF or EPS at a decent clip like 5% over the next decade. Its history would not suggest so, but with Peltz leaning on operating margins and advocating against bad acquisitions there is reason for optimism.
Finally, I always discount against the Standard & Poor's 500 return of 11% and use a terminal growth rate of 0%. Because the part of the business that is getting sold is excluded from my base earnings case, I am adding $3 per share in present value to the shares. It is not yet clear how much Wells Fargo will pay for the division, but it should be in that ballpark. This leads me to believe the net present value of a share of General Electric is around $23.3. That means I am siding with Ackman on this one and prefer to stay on the sidelines as General Electric trades quite a bit above that. In my opinion, Peltz has to work some serious magic to make a killing on this one.
Outlook
The outlook for General Electric is actually quite positive. With Peltz on board there will be significant pressure on the executives to do the right thing for shareholders. The transformation of the company away from finance and into pure industrial is a positive. General Electric has a global presence; although currently emerging markets are out of favor, over the long term this is a positive. The one concern I have about the long-term outlook for the firm is how well the Alstom integration will go. I have to admit that I may be biased here. Being Dutch I can’t help but notice how terrible the Air France-KLM (AF, Financial) combination has fared.
