Just as promised on its first-quarter earnings call, General Electric Company (NYSE:GE) has announced a deal to exit its transportation business as part of a wider plan to unload $20 billion worth of assets. The deal to merge GE transportation with Westinghouse Air Brake Technologies (NYSE:WAB), or Wabtec, is somewhat complicated but, in general, can be seen as a near-term positive for shareholders. However, it will do little to appease dyed-in-the-wool bears worried about the sustainability of the company's dividend and restructuring prospects.
Let's take a look at both sides of the story.
Near-term positive for shareholders
Let's start by breaking out who will own what after the merger. As you can see below, existing shareholders will be rewarded with stock, as well as future cash flow and dividends from the new Wabtec. So if you are a GE shareholder, you should have a keen interest in the rationale for the deal because you will be owning stock in Wabtec.`
After the Merger...
Receives 40.2% of shares in new Wabtec.
Receives 9.9% of shares in new Wabtec and $2.9 billion in cash.
Retains 49.9% of shares in new Wabtec.
In a nutshell, you could look at this deal as a kind of near-term "reward" for long-suffering GE shareholders, as GE's management is returning capital from GE Transportation via stock in the new Wabtec.
What's more, the deal has been structured in a tax-efficient manner. Specifically, GE Transportation will be first distributed to GE shareholders in a "tax-free spin- or split-off; then immediately merged with Wabtec," according to the deal presentation. Furthermore, the deal structure should accrue a net tax benefit of $1.1 billion to Wabtec.
A good deal for Wabtec
Wabtec's management certainly thinks it got a great deal. Aside from the tax benefit, the merged company is expected to generate $250 million in run-rate synergies by the fourth year after the deal, or around 3.2% of the combined 2017 revenue of GE Transportation and Wabtec. Although this figure is lower than the 5% many analysts assume for mergers, there are a couple of things to consider that suggest Wabtec is onto a good thing.
First, Wabtec's management estimates that the existing company currently trades on a 2019 EV-to-adjusted EBITDA multiple of 14, but the new Wabtec (which will roughly double in size) will trade on a 2019 EV-to-adjusted EBITDA multiple of just 9, after the tax benefits and synergies start to kick in.
Second, it's worth noting that Wabtec is merging with GE Transportation at a cyclical low point. For example, GE Transportation is expected to deliver around 300 locomotives in 2018; that compares with an average of around 670 over the last decade.
Since GE Transportation is only expected to start to rebound from a cyclical low in 2018, even the EV/EBITDA multiple for 2019 is still likely to reflect cyclically low earnings. In other words, in future years, earnings should rebound strongly -- and, all things being equal, the EV/EBITDA multiple will decline.
All told, it looks like a good deal for Wabtec.
Why GE bears won't be appeased, much
The bearish case for GE stock, for the most part, focuses on the deterioration in free cash flow (FCF) and the ongoing problems in the power segment. The influx of $2.9 billion in cash from Wabtec won't impress the bears much. Moreover, transportation is a highly cash-generative business for GE, and exiting it will trim FCF generation in the future.
Management has already told investors to expect earnings and, by implication, cash flow to be at the lower end of 2018 guidance -- its most recent guidance implies a $500 million cut in power segment profit, which will be hard to make up elsewhere.
As it stands, GE expects $6 billion to $7 billion in industrial FCF in 2018, which is intended to fund a $4.2 billion dividend payment. However, GE is pre-funding its pension plan to the tune of $6 billion in 2018 by borrowing the same amount. In a sense, GE is covering its 2018 dividend by borrowing money and relying on asset sales. In short, GE needs cash, and many investors may have preferred a deal with a higher cash component rather than the one outlined above.
The bottom line
An analyst with a glass-half-full approach would see the deal as progress on GE's restructuring plans and note that the cash flow will give the company more leeway to restructure the power segment before a bounce-back in total FCF generation in 2019. Meanwhile, the structure of the deal is a nice way to return capital to GE shareholders.
An analyst with a more pessimistic approach would worry about continued deterioration in the power segment and therefore see the cash from Wabtec as small potatoes compared to what GE could need to realize its restructuring plans while maintaining its current dividend.
All told, if GE can maintain its full-year 2018 cash flow guidance and FCF can improve markedly in 2019, then the Wabtec deal will turn out to have been a smart move. If not, it would represent a missed opportunity to possibly bring in some more much-needed cash. It's too early to tell right now, but what's undeniable is that the GE-Wabtec deal marks progress on GE management's strategic aims, and that can't be seen as anything but a plus.