If you're a millennial or older, you probably have at least a faint memory of the days that industrial conglomerate General Electric (GE 0.62%) was one of the world's largest, most influential companies. The company was a $400 billion titan before the financial crisis in 2008-2009 brought GE to its knees, where it's struggled to get up from ever since.
Today, the company's in the midst of a massive transformation, selling chunks of itself to slim down its business and get growth back on track. General Electric recently reported 2021 Q4 earnings, showing that its financials seem to be improving. Here's what investors need to know as the company prepares for more significant changes.
Simplifying General Electric
Sometimes the bold move is the right move, and it's not always easy to make. In November, General Electric announced plans to divest several business units into their own companies, leaving General Electric focused on aviation.
The summary of the changes and their timelines includes spinning off GE Healthcare as its own company in 2023. Its Renewable Energy, Power, and Digital business units will be combined and spun off in 2024. General Electric will retain a 19.9% equity stake in the healthcare company, but the overall transactions will leave shareholders with three independent companies focused on specific industries.
Conglomerates often trade at a discount on what their pieces might be worth separately. A company with many different businesses has to split its resources, mindshare, and money between its units. While these companies will be smaller individually, they can concentrate on their individual business models, potentially leading to better performance and higher valuations on the market.
Strengthening the balance sheet
The primary goal for management has been to restore its damaged balance sheet. General Electric has paid off $87 billion in debt over the past three years and continues making progress each quarter. It sold its aircraft leasing business in 2021 for $31 billion in (mostly) cash, paying down debt with the proceeds. It's also the last part of its financial arm to be divested, completely dissolving what was once the most prominent business at General Electric and what caused its collapse more than a decade ago.
The financials aren't yet where management wants them to be. As of the end of 2021 Q4, the company's balance sheet is leveraged at a net debt-to-EBITDA ratio of 3.3, and GE wants to get to 2.0 by the end of 2022.
This ratio means that the company's aiming to have $1 of annual operating profits for every $2 of debt on the books (net debt means you subtract out the company's cash).
The company's still working on things, but General Electric should be past any "doom" scenarios, because a net debt-to-EBITDA ratio of 3.3 isn't anything that should dramatically stress the business. GE even felt comfortable enough to make a $1.4 billion acquisition, buying BK Medical in 2021.
General Electric still holds additional assets that it could tap into if needed, including stakes totaling roughly $13 billion in value in Baker Hughes and AerCap. Management has noted that it intends to have all three eventual standalone companies carry investment-grade balance sheets.
Free cash flow is ramping up
There are a ton of moving parts in General Electric's financials, including ongoing restructuring in its business units like Power and Renewables to make them more profitable, as well as a lasting impact from GE Capital. However, investors can hone in on free cash flow to gain a broad sense of how things are progressing.
After generating roughly $600 million in adjusted (non-GAAP) free cash flow in 2020, General Electric increased its free cash flow to $5.1 billion in 2021. Management expects $5.5 billion to $6.5 billion in 2022 and more than $7 billion in 2023.
Free cash flow is vital to a business because it's real cash that the company can use to bolster its balance sheet or make acquisitions, which General Electric is actively striving for. There are a lot of unique items that could impact its bottom-line profits for a while, so investors may want to focus on free cash flow instead.
So should you invest in GE?
A reputation as a fallen giant, and the various financial moving parts, seem to have put a discount on General Electric stock. Its $5.1 billion in free cash flow against its $107 billion market cap values the stock at a price-to-free cash flow ratio of 21.
Other industrial companies trade at more expensive valuations, like Honeywell at a P/FCF of 26 and Eaton Corp at 36. This seems fair, given General Electric's current situation, but long-term investors may want to consider the potential value unlocked by the upcoming spinoffs.
It's difficult to put a number on what valuation the aviation, healthcare, and energy companies will separately command on the market. Still, as sentiment around General Electric improves with the company's financials, investors could benefit as management's big plans play out.