The agreement by ABB Ltd. (NYSE:ABB) to buy the industrial solutions business of General Electric Co. (NYSE:GE) sheds new light onto the strategic plans of both companies, and arguably makes them more investable. Let's take a look at the deal and what it means for investors in both stocks.

ABB buying GE Industrial Solutions

The rationale behind the deal for the buyer is that it gives ABB an underperforming and underinvested business that it can use to expand its margins and strengthen its global position in electrification. Meanwhile, GE sheds an underperforming non-core business, and gains $2.6 billion it can potentially use to accelerate its restructuring or make acquisitions.

An ABB uninterruptible power supply

An uninterruptible power supply used in a data center. Image source: ABB Ltd

While it all makes perfect sense, there are a few question marks for both companies here. Is the deal a good value for ABB, and what does the sale mean for GE?

These facts and figures point toward answers to those questions:

  • ABB is buying a business with $2.7 billion in annual revenue for a purchase price of $2.6 billion.
  • GE Industrial Solutions currently has an earnings before interest, tax, depreciation, and amortization (EBITDA) margin of 8%, and an EBITA margin of 6%
  • ABB plans to invest $400 million cumulatively over five years in order to generate annual cost savings of $120 million by the third-year and $200 million by the fifth-year. 

Why the deal looks a good value

If ABB can hit its targets, then it will win on this deal. For argument's sake, let's assume the real price to the buyer is $3 billion ($2.6 billion purchase price plus $400 million restructuring). If ABB can achieve $120 million of cost savings in the third year, then the acquired business will be generating at least $350 million in EBITDA. I'm assuming 2% revenue growth -- in line with management's projections for North American growth from 2017 to 2020 -- and underlying EBITDA margin of 8% plus the $120 million in cost savings. This means ABB is paying around 8.6 times its three-year-out EBITDA, and around 7 times its five-year-out EBITDA of $430 million.

Given that ABB currently trades on an enterprise value to EBITDA multiple of 11.8 times, that makes the acquisition look like a good value. In addition, the deal marks a continuation of ABB CEO Ulrich Spiesshofer's restructuring efforts. ABB is a value stock option in the electrical equipment sector and offers a healthy dividend yield. It isn't the most exciting stock from a revenue growth perspective -- comparable revenue grew just 2% in the first-half. However, its management is committed to releasing value by restructuring in order to expand margins and grown earning -- only in part due to pressure from an activist hedge fund. 

What it says about General Electric

ABB is assuming it can significantly boost GE Industrial Solutions' current EBITDA margin of 8%, and there are reasons to believe it could. While this is a positive for the buyer, it suggests that GE has been poorly managing the business. Moreover, if GE had kept the unit's margin closer to its peers, it surely would have commanded a higher price.

I'll explain.

ABB claims to be the second biggest player in the electrification market (switches, power systems, uninterruptible power supplies, etc.) but the first and third players -- Schneider Electric and Eaton Corp. (NYSE:ETN) -- both have notably higher margins than GE Industrial Solutions, as does ABB's existing electrification products (EP) division.

An ABB technician surveying some power conditioning equipment

Image source: ABB Ltd

Schneider's overall adjusted EBITA margin in the first half was 14.1% , and Eaton's electrical systems and services segment margin was 12.7%. Meanwhile, ABB's EP division had an operational EBITA margin of 15% in the second quarter.

Moreover, according to ABB's press release on the deal "this transaction will have an initial dampening effect to EP's operational EBITA margin. ABB commits to returning EP to its target margin corridor of 15-19 percent during 2020." The president of ABB's EP division, Tarek Mehta, further said he intended "to bring our combined business back into the target margin corridor during 2020."

Plans to expand GE Industrial Solutions' EBITA margin from 8% to 15% are all well and good, but the real question is why its margins are so low to start with.

Looking ahead

All told, assuming that this business's margins can be expanded as expected, buying it will turn out to be a good move for ABB, and makes its stock more investable. And while GE could have got more money for the unit if it had been better run, in the grand scheme of things, it only represents around 2.1% of GE's total revenue. Ultimately, its sale doesn't significantly impact the investment thesis for GE, but it should supply investors with a bit more confidence in management's determination to restructure.

Lee Samaha has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.