General Electric (GE +6.68%) management just made a quiet move that will possibly presage more drastic action in reducing the company's debt load and improving its creditworthiness. Specifically, GE modified the terms of its merger agreement with Wabtec Corporation (WAB +2.68%) in order to raise more cash for the company, but it also reduced the amount of Wabtec GE shareholders will own. Nonetheless, the modification is good news for investors, and here's why.
What happened
The change to the original merger agreement can be seen in the table below. GE shareholders are now getting a much smaller share, and Wabtec shareholders are getting a slightly larger share than originally agreed upon.
Image source: Getty Images.
GE's stake is currently valued at $3.4 billion, and it will be sold over time. Further, "With the increase in GE's stake in Wabtec, and increased proceeds as we sell down this stake, this transaction will further strengthen our balance sheet and support our de-leveraging plan," according to GE CEO Larry Culp.
|
Entity/Group |
Modified Terms |
Original Terms |
|---|---|---|
|
GE shareholders |
Receives 24.3% of shares in new Wabtec |
Receives 40.2% of shares in new Wabtec |
|
GE company |
Receives 24.9% of shares in new Wabtec and $2.9 billion in cash |
Receives 9.9% of shares in new Wabtec and $2.9 billion in cash |
|
Wabtec shareholders |
Retains 50.8% of shares in new Wabtec |
Retains 49.9% of shares in new Wabtec |
Data source: General Electric presentations.
Why the deal makes sense
Obviously, some GE shareholders will not be happy about the deal, but there three key reasons why it's a good move for them.
First, it raises the possibility that Culp will take similar -- but far more monetarily significant -- action with the healthcare spinoff. As previously discussed, Culp has already hinted that he might monetize up to 49.9% of GE Healthcare rather than the 19.9% that former CEO John Flannery planned to do. A conservative estimate for GE Healthcare puts it at around $42 billion, which suggests GE could monetize around $21 billion from the IPO, based on the 49.9% share.
Second, the Wabtec modification and a potential healthcare modification are relatively stress-free ways to raise cash in order to help GE pay the $26 billion in debt it has maturing by 2020. It doesn't involve a fire sale of assets on the cheap, nor does it dilute GE shareholders' equity in the way that an equity raise would.
Third, it's easy to look at it as a deal favoring GE bondholders over GE shareholders, but the reality is that if the bond markets don't have confidence in GE's debt reduction plans, then the company's stock price will suffer as the burden of debt grows with raising GE bond yields.
Furthermore, it's worth noting that Flannery's plan did nothing for the share price even as the bulls at the time got excited about a sum of the parts analysis, including the Wabtec and healthcare stakes for GE shareholders.
Check out the latest GE earnings call transcript.
Why Flannery's plan won't work
To understand the need for Culp to reassure the market, it's useful to go back to Flannery's plan to reduce GE's industrial net debt to earnings before interest, tax, depreciation, and amortization (EBITDA) ratio to less than 2.5 times in 2020 from around 3.5 times in 2018. A net debt/EBITDA ratio of 2.5 times or below is typically seen as suitable for investment-grade debt for industrial manufacturers
In a nutshell, Flannery planned to reduce industrial net debt by $25 billion from $50 billion (using a variety of potential sources that management claimed would add up to around $60 billion) and increase EBITDA to a level commensurate with a net debt/EBITDA ratio of 2.5 times -- an EBITDA figure of around $10 billion is implied by GE's figures.
The problem with Flannery's plan is that many of its underlying assumptions were wide of the mark. For starters, the $60 billion worth of potential sources for debt reduction included GE's shares in Baker Hughes, a GE Company (around 62.5% of market cap at the time) and the original 9.9% of Wabtec, but both stocks have lost around a third of their value since the Flannery plan announcement.
BHGE Market Cap data by YCharts
Similarly, GE management assumed it would hit its industrial free cash flow target of $6 billion to $7 billion in 2018, but we now know it will come in significantly below the bottom end of that range.
Furthermore, the Flannery plan assumed a "significant improvement at Power" from a cash flow perspective, according to CFO Jamie Miller -- but given the problems in the segment in 2018, it's highly unlikely that GE Power is going to hit the kind of assumptions that Miller was making for 2020 as part of the plan.
In other words, neither the numerator (net debt) nor the denominator (EBITDA) parts of the ratio looked easy to achieve, let alone the 2.5 times, and the potential for future contributions to GE Capital hasn't even been factored in yet.
Looking forward
All told, it's clear that Culp needs to address GE's plans to reduce debt, and the Wabtec merger modification is a step in the right direction. A similar move with GE Healthcare would also help allay the fears of bondholders and equity holders. The company has a long way to go fully restore confidence with investors, and it still has risk, but the latest move is a good one.
