General Electric (NYSE:GE) CEO Jeffrey Immelt demonstrated last week that a deft personal touch and a penchant for non-stop negotiation are pretty decent complements to a mammoth corporate checkbook. After meetings in recent weeks with French President Francois Hollande and economy minister Arnaud Montebourg, and a public defense before a French parliament committee, Immelt succeeded in persuading both French politicians and energy giant Alstom's board that GE's acquisition of prized company assets would benefit Alstom while leaving France's national interests intact.
In getting to board approval, GE weathered a competing joint bid from Siemens and Mitsubishi Heavy Industries, after the French government loudly protested GE's initial proposal, targeted solely at Alstom's energy business. In the revised deal, GE will own Alstom's gas turbine assets outright and will create three separate 50/50 joint ventures with the company, in renewable-energy products, nuclear steam turbines, and power grid equipment. GE has also agreed to create 1,000 additional jobs in France during the next three years. Finally, GE will sell Alstom its rail signaling business for about $825 million. The final deal is expected to be worth $17 billion, or $13.5 billion net of cash acquired by GE.
Why Jeffrey Immelt pushed so hard to secure this deal
This September will mark 13 years for Immelt as GE's CEO. You can see a significant storyline in Immelt's tenure in, of all things, the arc of GE Capital's finance receivables. These receivables -- that is, the personal and commerical loans GE originates through its finance arm -- are key drivers of the division's profitability, and that of the overall organization. Finance receivables have both expanded and declined as GE's strategy has evolved since Immelt replaced Jack Welch in 2001:
Immelt's years at the helm have so far bracketed the 2008 credit crisis, with roughly six years leading up to 2008 and six years since. Immelt initially pushed to grow the credit portfolio, taking receivables from $174 billion in 2001 to a 2008 peak of $372 billion.
This exposure on such a large scale ultimately became hairy for GE during the financial crisis. In one particularly unnerving stretch for shareholders, GE issued nearly a quarter of the guaranteed debt available to banks under the FDIC's guaranteed debt program known as the Temporary Liquidity Guarantee Program.
Immelt and his management team decided to restrain the growth of GE Capital and began to pare down its influence on the income statement. The management team deserves credit for this sea change: It's difficult to spend six years building up a division with primacy of revenue and profit, only to find that the call was a mistake. It's even thornier to reverse course and spend another six years slowly winding back that division.
Not just risk, but a meager return on assets
GE Capital is so huge, the deleveraging continues today. Should you have recently landed from another planet and opened up General Electric's financials (after all, what else would you do first after landing on Earth?), the finance arm would still appear to be the company's primary focus, as it contributes more than half of the company's profits at a margin of nearly 19% -- the rest of the business is split among no less than seven other operating segments. However, GE's management is very visibly bent on reducing GE Capital's profit contribution to 30%, with the industrial segments to supply the other 70% of company earnings.
The most persuasive reason to shrink the finance division lies in the fact that the return on GE Capital's assets isn't worth the risk the company takes. Management likes to track a metric called ENI, or Ending Net Investment, which is a measure of the total capital invested in GE's finance services business. ENI is essentially GE Capital's total asset base, including the finance receivables, and property it leases out, reduced by items such as deferred taxes and cash, as most cash is allocated for pre-funding of debt.
The company reported ENI of $380 billion at the end of 2013. GE Capital generated profit from continuing operations of $8.3 billion on this capital base, a return of just 2.1%. By comparison, GE's return on assets from continuing industrial operations was 4.6% in 2013.
This disparity of return on what GE derives from its industrial operations versus its lending business is why the Alstom transaction will benefit shareholders, even in present form.
Impact of the acquisition
Between the gas turbines business and joint ventures, GE will purchase the rights to approximately $15.25 billion of annual revenue. According to The Wall Street Journal, the deal in its approved format will produce a positive impact of $0.06 to $0.07 per share on 2016 earnings, versus an initial estimate of $0.08 to $0.10 tied to the original proposed transaction. Even at this projected reduced impact, GE stands to add roughly $600 million to its bottom line in year one (i.e. in 2016, as the purchase is slated to close next year).
GE had initially forecast that it could wring $1.2 billion of annual cost savings from the acquired operations over a five-year period. That number will probably be trimmed to about $1 billion now that some of the business is shared with Alstom in the form of joint ventures. Still, within five years, the operations could generate $1.6 billion of operating income annually, a return of nearly 12% on GE's initial investment.
To generate the equivalent return in the finance arm, GE Capital would have to increase its asset base by over $76 billion. Calculations like this explain why GE Capital is spinning off its consumer credit business into a separate company named Synchrony Financial, via an IPO later this year, with expected proceeds of approximately $3.5 billion. GE also announced this week that GE Capital is selling its Nordic division to Banco Santander for close to $1 billion.
All of this reconfiguring of assets starts to make sense when you look out over a five- to seven-year horizon. In addition to lowering its overall risk profile, General Electric is trading out assets of nominal return for those with a much higher future return. For shareholders, watered down or not, there's beauty in these numbers.