Along with mergers, acquisitions and new public offerings, spinoffs have been one of the common themes of the past couple of years as the pandemic-related economic crisis, combined with unprecedented easy-money policies, led to a free-for-all scramble of business changes. Some of these changes have been good for investors, while some haven’t.
One upcoming business split that the market seems particularly optimistic about is General Electric Co.’s (GE, Financial) planned division into three separate companies over the next couple of years, which it announced this past November and which it hopes will rejuvenate growth after a decade of earnings decline and two decades of lackluster returns.
The split into three different companies – Aviation, Health Care and Energy – will help define the company’s ongoing restructuring efforts, and several investing gurus with a diverse range of strategies are showing confidence in these changes by maintaining positions in the stock.
While the market loves a good turnaround story, though, that doesn’t mean all turnaround efforts will turn out to be good deals. The idea here is that splitting up can help the company streamline its operations, shedding unnecessary weight and attracting higher valuations, but the question we must ask is, will General Electric’s businesses really be better after the dust settles? If the answer is negative, then any rally in its stock price is doomed to be short-lived.
What’s in a conglomerate discount?
One common reason conglomerates cite for spinning off parts of their businesses into separate companies is the so-called conglomerate discount, which is when investors are not willing to pay high earnings multiples for a stock due to its conglomerate structure. Management believes the separate companies will be able to attract higher valuations, giving them advantages such as the ability to take on more debt at lower interest rates.
Calling it a conglomerate discount might be a bit of a misnomer, though. Amazon (AMZN, Financial) is a conglomerate, and so are other mega-cap tech stocks like Alphabet (GOOG, Financial)(GOOGL, Financial) and Meta Platforms (FB, Financial). The thing the market is discounting isn’t the conglomerate structure, but rather the “glue” that holds the conglomerate together. With big tech, it’s technology, but with General Electric, it’s access to capital. Nowadays, capital is much easier to come by than it was in the beginning of General Electric’s century-long history, so the stock’s valuation has dropped accordingly.
The other factor contributing to the company’s conglomerate discount is that, unlike the likes of Amazon, General Electric’s business is shrinking rather than growing. This has been a trend long before the beginning of the Covid-19 pandemic, as shown in the below chart:
In situations where a company finds itself unable to grow meaningfully, it will sometimes make the decision to prioritize cost-cutting measures over the health and growth prospects of the business. This often includes selling parts of the business or trying to run operations with a downsized workforce. Over the past three years, General Electric has cut its workforce by 44%, and it has stated in its recent earnings reports that it will need to continue cutting costs in order to meet its earnings goals.
While these may be necessary moves for the company if it doesn’t have good growth prospects, it tends to make the stock look unattractive. As the company downsizes, its stock will naturally be worth less money, especially if investors only see further downwards movement in the future.
Downsizing and hitting the restart button
Since General Electric has determined that downsizing is the only way to go in order for it to return to profitability, spinoffs could become an important part of that story by giving the newly independent companies a fresh start. They can start trading at a certain valuation, and if all goes well and they manage to grow, then they can do so without being bogged down by their parent company’s uninspiring historical price chart or other businesses.
General Electric plans to spin off its health care business in 2023 and its energy business in 2024. Due to the factors such as the ageing population and climate change, demand for health care is expected to increase strongly in the coming years and decades, and General Electric is getting in on the telehealth business with online GE Health Care Hub. The macro environment also looks good for energy, and the company generates energy from both non-renewable and renewable sources.
Timing is essential here, especially if the company wants to attract higher valuation multiples. The success of the spinoffs will depend largely on whether the company can finish the unpleasant parts of its restructuring before or after the fact.
Gurus and insiders seem confident
According to GuruFocus data, there are quite a few gurus who seem to believe in General Electric’s turnaround story, judging by their holdings in the stock as per the latest 13F filings. Among the premium gurus followed by GuruFocus, 23 have a position in General Electric, and the volume of guru buys has outpaced the volume of guru sells for the stock in the last two quarters.
Shareholders include gurus with a wide range of investing strategies. Andreas Halvorsen (Trades, Portfolio), T. Rowe Price, Catherine Wood (Trades, Portfolio), Mason Hawkins (Trades, Portfolio), Sarah Ketterer (Trades, Portfolio) and Jim Simons (Trades, Portfolio)' Renaissance Technologies all reported investments in General Electric in their portfolios for the third quarter of 2021.
Two of General Electric’s insiders have also been buying shares recently. Director Paula Rosput Reynolds was buying in March and November of 2021, while another director, Leslie Seidman, was also buying shares in November.
Takeaway
For investors of General Electric, the light at the end of the tunnel may be near. The company’s ongoing efforts to downsize and restructure have been tough on the stock, and for good reason, but spinning off its Health Care and Energy businesses could be the reset that the company needs to return to growth, provided it can finish all of the cost-cutting business before dividing itself up.
Buying trends among gurus seem positive, and recent insider buying is also a good sign, though we will need to wait in until the 13Fs for the fourth quarter of 2021 are released to see whether any gurus have bought or sold shares following General Electric’s announcement of its three-way split plans.
All in all, General Electric appears to be a guru-backed turnaround story that could unlock value by shaking off history at the right time, though it remains to be seen how effectively its businesses can growth after vigorous cost-cutting and restructuring. Hopefully it has avoided the faux pas of underinvestment.
