The Market Appears to Hate the Idea of a General Electric Breakup

In this segment from the MarketFoolery podcast, host Chris Hill and Motley Fool Asset Management's Bill Barker consider the response in the market to a Wall Street Journal article suggesting that General Electric (GE 0.69%) is exploring the idea of dividing itself.

Based on the stock-price drop toward a six-year low that followed, one might assume that even if Wall Street wants the giant conglomerate to make some changes, this is not one of them. But there are a number of deeper issues that may be in play here.

A full transcript follows the video.

This video was recorded on Jan. 17, 2018.

Chris Hill: The Wall Street Journal reporting that General Electric is reportedly considering breaking itself up. For anyone who has ever advocated for any company to be broken up under the idea that doing so will "unlock value," that appears not to be the case today, because shares of GE are trading down, and they're close to a six-year low. John Flannery, the CEO of General Electric, who's been there for just a couple of months or so, I think is the most interesting CEO to watch this year, and it's for things like this. It's for things like him saying, "Yeah, sure, we'll consider this. There are no sacred cows at this company, and in fact, we may break the whole thing up." Tell me why -- on the surface, this seems like not the most insane idea in the world. And yet, the reaction from the stock and the reaction from plenty of investors is, not only is this bit an idea that will unlock value, but this is just flat out a bad idea for a lot of reasons.

Bill Barker: It could be that, or it could be the reaction of late, which is that anything that GE says is going to reveal that things are worse than we thought. Every time any piece of information comes out these days, it's, there's more trouble than you could possibly have imagined regarding some of the underfunded pension obligations and the provisions that they have in the reinsurance business, it's just one bad report after another. And this doesn't really even come out as a report. I think the negative reaction that the market is placing on the news, if it qualifies as news, is, this will not be easy to achieve, and will not necessarily create value, because there's so much of a gray area in GE's financials that it's hard to separate. Although there are very distinct operations to the business, the financing of the businesses is muddled, and separating it all could be very difficult.

Hill: You're right. In the same way that Flannery has come out and talked about different divisions, I think it's natural and easy for a lot of investors to look at that company in those terms, here are the different pieces, in the same way that we've seen large conglomerates sell off various divisions -- speaking of which, we'll get to that later in the show in a completely different industry. But, we've seen that with Procter & Gamble over the last six years, "We're selling these divisions." Johnson & Johnson has done it to a lesser degree as well. What you're talking about with the financing, even though there are these specific divisions, is the financing so convoluted that it spreads across all of them? And, I guess where I'm going with this is, to some extent, is the way that they've been financing all these divisions likely to get them into some sort of legal trouble if that comes to light?

Barker: Not necessarily that they're doing something wrong at the moment as much as, GE Capital, for instance, has about $100 billion in debt, and that's how the capital division is financed. Well, the reason that it can get that debt at a reasonable price from the market is, other operations of GE, the Industrial division specifically and the Healthcare division, have good enough cash flows. So, when you look at the whole thing in its entirety, you have higher-rated bonds. The bonds that are issued by GE Capital are backed by all of GE, and the whole thing is better than the sum of the one part of GE Capital.

Well, if you split all of this up, these bonds are going to get rerated, and those that bought the bonds under the belief that they had the backing of these healthy cash flow businesses behind them are now going to be owning something with a lot more risk to it, and therefore, the price of the bond is going to go down, and they're going to want their money back in one form or another. Usually one of the forms that they might try to get their money back is suing, that that violates the covenants that they had or believed they had when they were buying the bonds. There's just so much. Given that there's more than $30 billion of underfunded pension obligations, who gets that? Who would like that part of the business?

Hill: I was going to say, in the divorce, who keeps that piece of furniture?

Barker: Yeah. So, who wants to buy any of these businesses is a different question from, if you buy the business, you have to buy some of the debt, some of the downside, some of the obligations. And that's a little bit messier.

Hill: One of the pieces of this story today, one of the ripple effects is, as GE's stock continues to drop -- again, closing in on a six-year low -- people looking at General Electric's place in the Dow Jones Industrial Average as being under threat. That at some point, if this thing drops much lower, then the people who decide what stocks stay in the Dow Jones Industrial Average, and there are just 30 of them, and which ones need to go, they may decide to boot it. And by the way, it's been nearly four years since this happened. This is not like the S&P 500, which rebalances every year. This is almost whenever they feel like it. It was March of 2014 when the Dow Jones people got together and said, "AT&T has got to go, and Apple, welcome to the club!"

Barker: At the end of 2013, GE was still on a roll. It was a nearly $300 billion market cap company. Today, it's less than $150 billion. So, about half the size, a little bit better than half the size. Its prominence is still significant in the American economy, and in a collection of the biggest companies. But it's obviously been lapped by many companies. It's nowhere near the largest company in America, which is a title it held at various times. And it's not going to get back there, certainly not by breaking up. And I think that should have no influence in what they do, whether they're a member of the Dow Industrials or not. But, it's an interesting question. If they were to break up, there's probably no part of that that you would especially want to have in the Dow, and there would be an opening.

Hill: But that would create greater demand for the stock, as there are funds that are just Dow funds, in the same way that there are funds and investors out there who are looking looking for dividend stocks. So, it's not just that GE has basically been cut in half since the end of 2013. It's also that they've cut their dividend.

Barker: Yeah. The number of purchasers of the stock is dwindling all the time, as evidenced by being down another 4.5% so far today. More sellers than buyers. When you talk about the most interesting CEO of the year, what's the thesis there?

Hill: That at any moment, John Flannery could come out and announce almost anything.

Barker: "We're going into cartoons!"

Hill: [laughs] Say what you want about the way that his predecessor, Jeff Immelt, ran that company. One word that was --

Barker: Not enough private planes for any one trip.

Hill: [laughs] Exactly. One of the words that has been associated with GE, certainly with GE the stock, over the last 20, 30, 40 years, is some version of the word steady. This has been a steady business, this has been a steady performer, and it's certainly been a steady payout of dividends. I think John Flannery is the most interesting CEO to watch this year because literally everything is on the table in terms of what he will do with this company.

Barker: As I said earlier, that I was going to go in this direction, your view is that this is a "so crazy it just might work" thing with him. Anything might go. And right now, the market is looking at it and saying, "That's crazy!" And you're saying, "Well, yeah! It's so crazy, it just might work."

Hill: It might work. And I don't own this stock, but I totally understand why today, a majority of investors who have a say in what's happening with GE are looking at it and just focusing on the first two words of that phrase. They're just looking at GE and saying, "That's so crazy! And I want no part of it." But, that's why I think it's going to be interesting to see how all this plays out. It's not inconceivable that in three to five years from now, Flannery has gotten General Electric going in such a way that we look back and it's the 10,000 word article that's written about, "Here's how Flannery turned it around. Here are the bold moves he made, and here's how he turned it around."

Barker: It's been a long period of suffering for GE shareholders, and I'm sure they're hoping that it gets better. The stock has returned a little bit, over 1% per year over the last 15 years, as compared to 10% for the market. This has been a brutal time. A lot of the pain has been experienced in the last 12 months, as the stock has almost been cut in half in that period. So, right now, the reflection of the stock price is more reflecting the information that has come into the market since Flannery came in, rather than his or the company's actual performance. I think there's just more and more being revealed that things were not what they seemed to be.