General Electric's (NYSE:GE) announcement earlier this month that it planned to separate into three different companies certainly surprised the market. However, it should also have delighted investors who believe the company currently trades at a "conglomerate discount."
According to that thinking, when it's broken up, the constituent parts should trade at higher valuation multiples than their implied valuation as part of a conglomerate. Let's take a look at the validity of that argument.
The breakup was one key consideration among many
It's important to note that the split is only partly about the "sum of the parts" argument. In fact, from management's perspective, the purpose of the breakup is to allow the businesses to be run with greater focus and have capital structures more tailored to their own distinctive "strategies and industry dynamics," as CEO Larry Culp put it in the investor update.
In plain English, the businesses will be better run and have more freedom to engage in mergers and acquisitions, among other activities. As such, their earnings growth will receive a boost from a separation. Combined with the valuation rerating (the sum-of-the-parts argument), investors should benefit from a significant increase in returns from the split.
What is GE planning?
The plan is to spin off GE Healthcare in early 2023, with GE retaining a 19.9% stake. In addition, GE Power, GE Renewable Energy, and GE Digital will combine as one company and then spin off in early 2024. The remaining GE will be an aviation-focused company.
It makes sense to combine the fossil-fuel-driven power business (gas turbines, steam power, and power conversion) with renewable energy, as it offers electricity-generating customers a comprehensive offering. Meanwhile, GE Digital (GE's digital and internet of things (IoT) capability) is currently focused on improving transmission and distribution networks and improving GE's services offerings in power and renewable energy.
GE Aviation's enterprise value reaches $92 billion
The closest peer is Raytheon Technologies (NYSE: RTX). Raytheon's Pratt & Whitney sells its geared turbofan engine for the Airbus A320 aircraft, and competes directly with the LEAP engine from CFM International (a joint venture between GE Aviation and Safran).
A profile of Raytheon and its growth prospects is in the link. According to Wall Street analysts, and based on the current market cap, Raytheon will have an enterprise value (EV), representing market cap plus net debt, of $154.7 billion in 2023, while generating $10 billion in earnings before interest and taxation (EBIT). In other words, its EV/EBIT multiple in 2023 will be 15.3 times EBIT.
Turning to GE Aviation, Culp believes that the segment will return to its 2019 level of segment profitability of $6 billion in 2023. Applying Raytheon's EV/EBIT multiple of 15.3 times EBIT to GE Aviation's $6 billion in EBIT in 2023 gives an estimated enterprise value of $92 billion for GE Aviation.
GE Healthcare's enterprise value comes in around $59 billion
The business' two critical competitors in imaging and diagnostics are Royal Philips and Siemens Healthineers. Wall Street Analysts have Philips trading at an EV/EBIT multiple of 13.9 times EBIT in 2023, and Siemens Healthineers at 19.9 times on the same basis. The average of the two gives a multiple of 16.9 times.
During the investor presentation, Culp reiterated his view that GE Healthcare would generate $3 billion to $4 billion in segment profit in 2023. Applying those figures to the target multiple above gives an EV range of $50.7 billion to $67.6 billion for GE Healthcare, the midpoint of which is $59 billion.
GE Power is worth $8.4 billion and Renewable Energy is nearly $29 billion
This is where things get a little complicated. Culp expects GE Power to generate $1 billion to $2 billion in segment profit in 2023, but the implication is that GE Renewable Energy will be breakeven at the time.
For reference, GE is building its nascent offshore wind business from scratch while turning around the hydro and grid solutions businesses -- the onshore wind business is already profitable.
GE Renewable Energy's two key competitors are Vestas Wind Systems and Siemens Gamesa Renewable Energy. GE Renewable Energy is aiming to hit the kind of high-single-digit margins that both companies have achieved. They trade at EVs of 1.7 times and 1.4 times estimated sales in 2023. Using this as a guide, and assuming GE Renewable Energy hits $18 billion in sales in 2023, it should have a valuation of $28.8 billion.
Siemens Energy combines a 67% stake in Siemens Gamesa and the former Siemens' gas and power business, GE Power's key competitor. Based on my calculations and management's estimates, the gas and power business of Siemens Energy is being valued at just 5.6 times its potential earnings in 2023. Proscribing that figure to GE Power -- where Culp expects $1 billion to $2 billion in profit in 2023 -- gives a midpoint valuation of just $8.4 billion.
General Electric looks like a good value
Adding all these valuations together gives roughly $188 billion. Stripping out a few billion in costs for the split and the midpoint of the expected net debt of $33 billion to $37 billion in 2023 gives a market cap of $150 billion for the combined business. Given that GE's market cap is currently $118 billion, that implies a 27% upside to the stock.
All told, GE stock looks like a good value, and the split could see significant upside for the stock.