General Electric's (NYSE:GE) new CEO, Larry Culp, is doing the right thing by holding off on giving financial guidance until it can be issued with "conviction and confidence," as he said on the third-quarter earnings call. Given the tendency of his predecessor, John Flannery, (and that of current CFO Jamie Miller) of providing earnings and free-cash-flow guidance that the company consistently fell short of, it's understandable that he'd seek to restore a degree of faith in GE's forecasts by waiting to make them until the numbers are more solid.
Unfortunately, that absence of guidance has created a period of uncertainty, and GE's declining stock price has led to no end of speculation over the company's prospects. With this in mind, let's consider the best ways to put a value on GE, and why restoring confidence is such a key part of Culp's early strategy as CEO.
Sum-of-the-parts analysis of GE
It's not difficult to put together a rough approximation of what GE is worth by valuing each of its constituent parts separately, then stripping away net debt and non-operating liabilities, and adding in non-operating assets. This is known as a sum-of-the-parts (SOTP) analysis.
The approach has obvious merits, not least because it reminds investors that GE possesses two world-class businesses (GE Aviation and GE Healthcare) that are set to generate something near $10 billion in combined segment earnings in 2018. That figure makes GE look very cheap at its current market cap of around $68 billion.
For example, Siemens Healthineers and Transdigm (an aerospace-focused company) currently trade on an enterprise value (market cap plus net debt), or EV, of around 17 to 18 times earnings. Applying these ratios to the forecast earnings of GE Aviation and GE Healthcare would give those two units alone an EV of around $170 billion to $180 billion.
Assuming GE Power can achieve the low-to-mid-single-digit percentage margin that Siemens is aiming for in 2019, then the business is worth at least $10 billion. Factor in GE's stakes in Baker Hughes and Wabtec, and one ends up with a total EV of around $210 billion. (No, we haven't touched on GE Capital yet -- I'll get to that in a moment.) Strip out GE's net debt of around $115 billion, and the corresponding market cap would be around $94 billion, or around $10.80 per share.
Sound good? Read on.
GE Capital is the key
There are two issues that render the calculation above inaccurate, and both relate to GE Capital -- and equally importantly, the level of confidence that investors have about it.
First, SOTP analyses are usually used to value companies that could effectively be broken up -- by management restructuring or via takeover bids. This is practically impossible in this case because the primary purpose of GE Capital is to support the conglomerate's industrial businesses. Conversely, GE Capital now needs the rest of the company's earnings and cash flow to support its debt.
According to GE's SEC filings, "GE Capital has the right to compel GE to borrow under certain of these credit lines and transfer the proceeds to GE Capital as intercompany loans." Simply put, GE Capital can't be entirely separated from GE.
Second, no one -- not even GE's management -- knows how to accurately value GE Capital. There are myriad variables at play here, and many risks. If it isn't SEC investigations into GE's accounting practices, it's inadequate reserves at its insurance business. If it isn't rising GE bond yields -- which will make it costlier for it to refinance debt -- it's credit rating agencies downgrading the company. And then there are the analysts who speculate that GE Capital won't earn anything by 2020, and assert that it has a $20 billion funding gap it will need to fill by that year.
How to value GE Capital?
Culp points out that GE Capital's assets match its liabilities, and he's already busy selling assets in order to deleverage the company. A quick look at GE Capital's balance sheet shows he's right -- total assets excluding goodwill are around $127 billion compared to liabilities of $117 billion.
That's the good news. But the bad news is that GE still has insurance and tax liabilities, and given the company's recent history of delivering disappointing news, it's understandable if the market is nervous about these issues.
Analyzing GE on a SOTP basis with GE Capital valued at zero might suggest a price target of $10.80 per share, as argued above, but it's far from that simple, and the company can't be valued by assuming that a major part of GE Capital won't remain connected to it.
Where does this leave GE's valuation?
It's one thing to look at the numbers and determine the core worth of GE, but the fact is, intangible factors like investor confidence are also a key part of any such calculation. That point applies whether you're applying SOTP analysis or any other valuation method.
If the market had confidence in GE's debt reduction plans and earnings guidance, then its bonds would be better priced -- making it easier to refinance debt at GE Capital, and raising the overall SOTP value. Similarly, if the market believed in GE's ability to generate significant FCF in the coming years, then it wouldn't worry so much about the liquidity issues emanating from GE Capital.
The good news is that GE shareholders have some reason to be optimistic. Once Culp gives that postponed earnings and FCF guidance and offers an update on the state of GE Capital, it's likely that confidence will return. That will make managing GE's debt burden easier and therefore improve its fundamentals, too.