GE is smart to simplify, but its pledge of $20-billion in divestitures is no game-changer.
The $200-billion industrial conglomerate last week reported its biggest earnings miss in at least a decade and drastically chopped its 2017 profit and cash flow outlook. CEO John Flannery acknowledged the "completely unacceptable" results and vowed to make some major changes "with urgency." These include moving away from the earnings adjustments that have so irked investors, improving cash flow and margins and getting rid of operations that suck up money and management attention without much payoff.
These are all good thoughts that should please investors. Mr. Flannery's frankness about General Electric Co.'s challenges was a refreshing contrast to the defensiveness of predecessor Jeff Immelt. But investors seem a bit drunk on his can-do attitude: After plunging as much as 6.3 per cent on Friday following the earnings news, GE's stock actually rebounded to end up higher by the end of the day. That is silly. Putting aside the fact that Mr. Flannery was wishy-washy on the prospect of a dividend cut, the company's latest results belie some serious underlying problems, particularly in its power division, and nothing he's proposing is a quick fix.
Let's focus on these $20-billion of divestitures for now. At about 10 per cent of GE's market value, this isn't a major breakup. Despite Mr. Flannery's allusions to additional divestiture options, I wouldn't expect to see anything drastic from him. He told CNBC on Friday that he saw value in the conglomerate structure, and praised the organic growth opportunities in the company's aviation and health-care businesses to the New York Times. Besides, a massive split into three or four different entities would cause tax leakage and disadvantage its digital efforts.
Among the most likely divestitures are GE's energy-connections and lighting businesses, the consumer light-bulb component of which it's already looking to sell. Another possibility is the transportation business, which is struggling amid weak demand for locomotives and looming margin pressure from Chinese competition. GE should also probably think about more formally separating itself from the energy operations it combined with Baker Hughes Inc. earlier this year. It retains a 62.5-per-cent stake in the combined entity -- and has to continue to report some measure of its pressured organic revenue and operating profit.
Wouldn't you know it, in a report earlier this month, JPMorgan Chase & Co.'s Steve Tusa got to a roughly $20-billion valuation combined for GE's energy connections, lighting and transportation businesses, using a sum-of-the-parts analysis based on EBITDA multiples. It's worth noting, however, that the same analysis indicates GE should be worth about $18 a share -- about 25 per cent below the current share price.
There's something to be said for simplicity as a value in and of itself. It's harder to turn around a sprawling conglomerate. Previous analyses have shown breakups often create more value than sum-of-the-parts estimates would have indicated once businesses are unshackled from corporate bureaucracy. But I have a hard time believing that it's those darn transportation and lighting units that have kept investors sidelined. All the financial engineering in the world can't make up for weak operating results.
GE also has to be careful. Transportation, for example, is a highly cyclical business that wouldn't be particularly attractive as a stand-alone entity and may not attract many buyers. Selling on the cheap would further dilute GE's cash flow, exacerbating, rather than ameliorating, its current situation.
Mr. Flannery is saying all the right things, but even he acknowledges this is going to be a tough slog. Investors should be prepared for one, too.
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Brooke Sutherland is a Bloomberg Gadfly columnist covering deals. She previously wrote an M&A column for Bloomberg News.