The key to the investment case for General Electric's (GE -0.69%) stock lies in the successful execution of its breakup plan. As such, the most significant risk to the stock lies precisely in the company's ability to navigate market conditions and deliver the three new companies with investment-grade debt. Here's a look at the puts and takes, and what investors can expect in the future.
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General Electric's breakup plan
A quick reminder of what management is planning:
- GE Healthcare will be spun off in early 2023, with GE retaining a 19.9% stake.
- GE Renewable Energy, GE Power, and GE Digital will be combined and then spun off in early 2024.
- The remaining GE will be an aviation-focused company.
The case for the breakup lies in two compelling arguments. First, the company probably trades with a so-called "conglomerate discount" as the sum of its parts appears to be worth more than how they were valued as one company. So, splitting them up would release value. Second, the companies would be better run as separate entities and therefore generate more cumulative profit if run as individual companies.
General Electric's debt plans
The critical risk comes down to the debt loads that GE will allocate to each company. Management's plan is for each company to have investment-grade debt. There's no set-in-stone definition of investment-grade debt, as acceptable debt loads differ across industries and the debt ratio is just one variable that rating agencies look at.
However, GE plans for the company to have a net debt-to-EBITDA ratio of fewer than 2.5 times EBITDA in 2023, so we can assume that management feels this is acceptable to receive an investment-grade rating from agencies.
Obviously, if GE achieves its targeted overall net debt/EBITDA ratio, all three companies could be listed with debt loads adjusted to their respective EBITDA. In this way, they would all have investment-grade debt.
Digging into the weeds, back in March 2021, management outlined expectations for net debt of $33 billion to $37 billion and a net debt-to-EBITDA ratio of fewer than 2.5 times in 2023. Some simple math implies EBITDA would be $13.2 billion to $14.8 billion in 2023 under these assumptions.
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Fast-forward to the breakup presentation in November, when CFO Carolina Dybeck Happe told analysts "about $13 billion to $14 billion of EBITDA and less than $35 billion of net debt." She then went on to reiterate: "I would also say that the equity stake in healthcare gives us more strategic flexibility here. So today, we're saying three investment grades and then exactly what that would look like, we will come back to you closer to spin."
Key risks to the plan
Achieving investment-grade debt for all three companies is achievable, but it won't be smooth sailing. Moreover, the plan phases some threat over the timing of earnings and the price of the GE Healthcare spinoff, plus the subsequent value of GE's remaining 19.9% stake in GE Healthcare.
First of all, Dybeck Happe's assumption of $13 billion to $14 billion in EBITDA in 2023 is significantly above Wall Street analyst expectations of $12 billion.
Second, as previously noted, those EBITDA and net debt figures would just put GE within an investment-grade debt ratio of 2.5 times EBITDA or less. As such, there isn't much room for error.
That's a concern given the uncertainty around all three businesses -- for example, the pace of the commercial aviation recovery for GE Aviation. Moreover, GE Healthcare faces some potential threats to its EBITDA expectations in 2022, given the resurgence of the pandemic potentially delaying installations of large medical equipment. In addition, management has been walking back expectations for GE Renewable Energy on the back of potential push out of orders due to the extension of production tax credits.
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Another complication in GE's plan is that it involves getting to a certain level of EBITDA in 2023 and then splitting off the businesses with debt loads allocated in line with EBITDA -- starting with GE Healthcare in early 2023.
Given the fact that GE Healthcare shouldn't carry a debt load more than 2.5 times EBITDA in 2023 and the original plan ($13 billion to $14 billion in EBITDA in 2023) doesn't give much room for error, GE Healthcare's earnings in 2022 & 2023 must fall in line with management's expectations at the time of the breakup announcement.
Similarly, if GE is going to use proceeds from the healthcare spin-off or subsequent stake sale, then it will need a good earnings trajectory at GE Healthcare in order to get a good price.
After that, it's also critically important to the plan that GE Aviation recovers in line with expectations in 2024, and GE Renewable Energy as well. However, given the difficulty of predicting the pace of the aviation recovery and the wind power market, it won't be an easy task to predict their EBITDA in 2024.
What to expect from General Electric
All told, it's essential for GE's management to maintain its guidance for 2023 and, in the near term, affirm it's on track for its original expectations for GE Healthcare in 2022 & 2023. It's something to look out for closely when management speaks to investors next.
