Last November, new General Electric (NYSE:GE) CEO John Flannery revealed a plan to slim down and focus the company on three key businesses: power (including renewable energy), aviation, and healthcare. He also raised the possibility of GE exiting its majority stake in Baker Hughes, a GE Company (NYSE:BKR), its oil and gas business.
However, investors haven't been content with the pace of GE's turnaround. The power business is facing a deeper downturn than initially expected, while the GE Capital segment reported a surprisingly large $7.5 billion charge related to its insurance liabilities in early January.
As a result, General Electric will take even more radical steps to shrink itself. On Tuesday, the company said it will spin off its healthcare division as a separate publicly traded company. GE also confirmed that it will exit its investment in Baker Hughes. Let's take a look at what these deals mean for shareholders.
Healthcare will become a stand-alone company
GE Healthcare is one of General Electric's two premier businesses, along with GE Aviation. It achieved an operating profit of $3.5 billion last year on $19.0 billion of revenue. Management expects revenue growth of around 3% and operating profit growth of at least 5% this year. GE Healthcare is also a reliable cash cow, with a greater than 100% free cash flow conversion rate.
While the healthcare business has performed very nicely under the GE corporate umbrella, there aren't meaningful synergies with the other parts of GE. Additionally, as a separate publicly traded company, it would be easier for the healthcare business to incentivize management with stock-based compensation, or to pay for potential acquisitions with stock.
As a result, GE has decided to sell about 20% of the healthcare unit and split or spin off the rest to GE shareholders. GE Healthcare will take over debt and pension liabilities worth about $18 billion as part of the split, which the company expects to complete within 12 to 18 months.
Healthcare is a secular growth business, so this piece of General Electric is quite valuable -- and has probably been undervalued by investors up until now. Siemens recently listed its competing Siemens Healthineers unit and sold a 15% stake in that business, which is currently valued at more than $40 billion.
GE Healthcare is a bigger business and routinely earns more profit than Siemens Healthineers. As a result, it should be worth at least as much, despite starting out with a bigger debt and pension burden. This puts the value of the 80% stake that will be distributed to GE shareholders at around $4 per share.
The last big divestiture
As part of its announcement on Tuesday, GE stated that its previous plan to divest about $20 billion of assets is "substantially complete." Indeed, the company is set to receive $9.8 billion of cash proceeds over the next 12 months from four major asset sales, along with approximately $1.9 billion of Westinghouse Air Brake Technologies (NYSE:WAB) stock. GE shareholders will receive an additional $7.6 billion of Wabtec stock as part of the sale of the company's freight locomotive business. The GE Lighting division is the last major asset up for sale under this plan.
However, General Electric has now confirmed that it will also exit its investment in Baker Hughes within two to three years. Based on Baker Hughes' recent stock price, GE's 62.5% stake is worth more than $23 billion today.
Thus far, GE hasn't decided on the mechanics of exiting Baker Hughes. It could sell the entire stake for cash, spin off its Baker Hughes shares to GE stockholders, or implement some combination of those two strategies.
What does it all mean for shareholders?
As GE executes the simplification plan described above, reinforcing its balance sheet will be one of its top priorities. Indeed, the company is on the brink of having its credit rating cut, due to a combination of heavy debt and pension obligations and lower diversification going forward.
Fortunately, there's some good news for investors. First, rising interest rates have knocked about $5 billion off of GE's pension deficit year to date. Second, GE has identified more than $60 billion of potential cash sources that it can use to reduce its net debt and pension obligations by at least $25 billion by the end of 2020.
Sending $18 billion of debt and pension liabilities to the healthcare company will accomplish most of this goal. The other potential sources of cash include internal free cash flow generation in excess of GE's dividend, the cash proceeds from its asset sales, the sale of its Baker Hughes and Wabtec shares, and the proceeds from selling 20% of the healthcare unit.
In total, General Electric plans to pay down an additional $9 billion of debt and make a roughly $3 billion capital contribution to GE Capital within the next couple of years. It also wants to build up its cash balance to at least $15 billion (compared to $7.5 billion today, excluding Baker Hughes). However, despite prodding from analysts, management was vague about what will happen with the rest of the more than $60 billion it has identified.
CEO John Flannery hinted that General Electric would be willing to use some of this cash to reduce its insurance risks. The company could also opt to distribute part of its Baker Hughes stake to investors, rather than selling it for cash. GE could even have excess cash available for share buybacks or a special dividend, defying fears about a cash crunch.
The key point is that GE has plenty of good options going forward. Over the next few years, shareholders will receive stock in Wabtec and GE Healthcare worth about $5 per GE share. Furthermore, GE will dramatically improve its balance sheet. Crucially, the remaining company will probably recoup all of the lost earnings from its divestitures within a few years, driven by deep cost cuts and the growth of its aviation division. This could drive big gains for GE shareholders over the next few years.