Source: PaxForex Premium Analytics Portal, Fundamental Insight
General Electric's announcement earlier this month that the company plans to split into three separate businesses definitely amazed the market. Nevertheless, it should also have pleased investors, who are sure that the company is trading at an incredible discount as a conglomerate.
According to this view, when the company splits up, its fundamental parts should trade at higher valuation multiples than their assumed valuation as part of the conglomerate. Let's look at the validity of this argument.
It is essential to remark that the split is only partly related to the "sum of the parts" argument. In fact, from a management perspective, the purpose of unbundling is to allow the businesses to manage more purposefully and have a capital structure more tailor-made to their own peculiar "strategies and industry dynamics," as CEO Larry Culp put it in an investor update.
Simply put, businesses will be better managed and have more freedom to take part in mergers and acquisitions, among other activities. Thus, their earnings increase will get a boost from unbundling. Combined with increased valuation (the "sum of the parts" argument), investors should see a significant increase in earnings from the separation.
GE Healthcare is scheduled to spin off in early 2023, with GE retaining a 19.9% stake. Moreover, GE Power, GE Renewable Energy, and GE Digital will be merged into one company and then separated in early 2024. The remaining GE will be an aviation-focused company.
It does make sense to merge the fossil fuel energy business (gas turbines, steam power, and energy conversion) with renewable energy, since it proposes a broad offering to power generation customers. At the same time, GE Digital (GE's digital and Internet of Things (IoT) division) is currently focused on improving GE's transmission and distribution networks and improving GE's energy and renewable energy service offerings.
The closest equivalent of GE Aviation is Raytheon Technologies. Raytheon Pratt & Whitney is selling its geared turbofan engine for the Airbus A320 and competing directly with the LEAP engine from CFM International (a joint venture between GE Aviation and Safran). According to Wall Street analysts and based on current market value, Raytheon will be worth $154.7 billion in 2023, which is market value plus net debt, with earnings before interest and taxes (EBIT) of $10 billion. In other words, the EV/EBIT ratio in 2023 will be 15.3 times EBIT.
Culp is sure the division will return to its 2019 segment profitability level of $6 billion in 2023. Applying Raytheon's EV/EBIT multiple of 15.3 EBIT to GE Aviation's EBIT of $6 billion in 2023 gives GE Aviation an enterprise value estimate of $92 billion.
The company's two main rivals in imaging and diagnostics are Royal Philips and Siemens Healthineers. Wall Street analysts value Philips 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 figures yields a ratio of 16.9.
During a presentation to investors, Culp reiterated his view that GE Healthcare will generate between $3 billion and $4 billion in segment profits in 2023. Applying these numbers to the target multiple above gives an EV range for GE Healthcare of $50.7 billion to $67.6 billion, with a midpoint of $59 billion.
Then things get a little more complex. Culp anticipates GE Power to generate between $1 billion and $2 billion in segment profit in 2023, but the implication is that GE Renewable Energy will break even at that time.
For the record, GE is building its fledgling offshore wind development business from the ground up while rolling out its hydropower and grid solutions business - the offshore wind development business is already profitable.
GE Renewable Energy's two main rivals are Vestas Wind Systems and Siemens Gamesa Renewable Energy. GE Renewable Energy aims to achieve the kind of high margins that both businesses have accomplished. They are trading at 1.7 times EV and 1.4 times estimated sales in 2023. Assuming that and considering GE Renewable Energy reaches $18 billion in sales in 2023, it should be worth $28.8 billion.
Siemens Energy consolidates a 67 percent stake in Siemens Gamesa and the former gas and power business of Siemens, a key competitor of GE Power. According to management calculations and estimates, Siemens Energy's gas and power business is valued at just 5.6 times potential earnings in 2023. If you apply that figure to GE Power, where Culp expects $1 billion to $2 billion in profits in 2023, the average estimate is just $8.4 billion.
If you add all of these estimates together, it comes to about $188 billion. If you strip out a few billion in split costs and the midpoint of foreseen net debt of $33 billion to $37 billion in 2023, the market value of the combined business would be $150 billion. Given that GE's current market value is $118 billion, this represents a 27% upside potential for the stock.
Overall, GE stock looks like a good value, and the stock could grow significantly as a result of the split.
As long as the price is below 107.30, follow the recommendations below:
- Time frame: D1
- Recommendation: short position
- Entry point: 101.05
- Take Profit 1: 96.20
- Take Profit 2: 93.70
Alternative scenario:
If the level of 107.30 is broken-out, follow the recommendations below:
- Time frame: D1
- Recommendation: long position
- Entry point: 107.30
- Take Profit 1: 111.80
- Take Profit 2: 114.40
