Since the announcement that GE would seek to divest the majority of GE Capital, I have been considering how best to model this action from a valuation perspective. The process of divestment is likely to take several years and will be enormously complex, considering the role GE Capital has played?in GE’s overall business strategy for the last 34 years.
Due to the complexity of this corporate action, it is hard to get a handle on just what the effect of it will have on the value of the company to its owners. This article provides a back-of-the-envelope sketch, based on the four main drivers of valuation discussed in The Framework Investing–revenue growth, profitability, investment level & efficacy, and “balance sheet effects.” For more information about our original valuation, referenced in this article, please see our full IOI Institutional Report on the company.
While this is a back-of-the-envelope look at GE’s valuation, I have tried to dig deeper than the superficial “analysis-by-pie-chart” article that ran in Barron’s the day?after the GE announcement was made.
Background
The impression that Jack Welch’s tenure left on the investing community is so strong that some people have a difficult time remembering?what GE looked like before Welch?took the reins. The pre-Welch GE was a sprawling, unfocused conglomerate of which less than a percent of revenues and profits were derived from its financing arm.
To Welch’s credit, GE is an enormously more focused and well-disciplined company than it was when he took charge. His organizational changes, while unpopular among the rank and file at first, has become a durable part of GE’s corporate culture. While cutthroat and perhaps unpleasant for workers on the inside, this focus served GE’s owners well. GE’s industrial businesses have strong competitive positions and are protected by solid intellectual property and other “soft” assets such as relationships with government officials around the world, reputation for professionalism, and the like.
Welch also began building up an enormous leasing business almost as soon as he became CEO, and this leasing business ballooned into the GE Capital division (a.k.a. GECC) investors know now. This business originally focused on leasing out industrial equipment such as railroad cars, but, as Welch discovered the earnings-smoothing advantages of finance businesses and morphed this business into what amounted to an unregulated consumer and merchant bank. This looked like a great move in the pre-credit crisis days, but the fragility of an over-levered, under-regulated bank to?Black Swan events led to an almost terminal risk situation for the company during the 2008-2009 crisis.
The present CEO, Immelt, is keeping the original kernel of the finance business–the leasing business “verticals” associated with GE’s product lines–but excising the banking assets. In our view, this will leave GE with the best of both worlds: a strong and focused industrial portfolio paired with associated leasing businesses that provide market intelligence and international tax shelters.
As the company sells off its financial assets, it is intending to plow the money into a $50 billion share buy-back. Because the profits of the firm will shrink because of?the sell-off, the only way it can maintain profits on a per-share basis is to have fewer shares outstanding. While the GE divestment and share buy-back program will take many quarters to execute, I have modeled them as though they are occurring instantaneously.
Revenues
About $43 billion of GE’s $149 billion of revenues is generated by GECC. The company has suggested that GECC’s share?will shrink to about 10% of overall revenues, so the first thing I did to the IOI model was to lop off a big chunk of revenues. Our back-of-the-envelope assumption is a best-case revenue drop of 22% and a worst-case drop of 25%. This assumption, combined with a subsequent 5% and 1% best- and worst-case average growth for the remaining four years of our implicit forecast generates an average annual fall in revenues of 1% (best) and 5% (worst) over the full five-year explicit modeling period. In the best case, GE would be generating about $141 billion of revenues in 2019; worst case, it would be generating about $116 billion.
Profits
This is the most difficult part of the GE divestment puzzle due to the opacity of the firm’s tax sheltering structures. Over the last three years, the Industrial divisions of GE have generated Owners Cash Profit (OCP) margins of between 11% and 14% (GE splits out the Industrials business from the GECC business in its statement of cash flows, so we are able to calculate segment-level OCP directly in this case). We believe that the parts of GECC that GE will retain are responsible for the lion’s share of the structures that allow GE to shelter its profits from taxes. If our assumption is correct, the OCP margin the firm will be able to generate will fall within our best- and worst-case assumption range of 16% and 12%, respectively.
That said, the tax shelter structures GE has put in ?place are phenomenally complex and, analysts relying only on public statements (or court proceedings, in the case of GE) really have little visibility into post-corporate action tax shelter efficacy. From what I know right now, it seems that our present profitability scenario range is fine, but we may have to reassess as more information becomes available.
Investment Level & Efficacy
We do not foresee a large change in investment level or efficacy as a result of this corporate action. As a result, we’ve kept our?investment level and medium-term growth assumptions unchanged from our original analysis.
Balance Sheet Effects
In my mind, the large, positive stock market reaction to the GECC divestment announcement was mainly caused by investors pricing in lower hidden risks to GE’s balance sheet brought about by the divestment plan. GECC is, to an outside investor, too much like a black box to feel completely comfortable with, so its removal should have a slightly positive effect on the valuation. However, since this positive effect is difficult to quantify and since IOI disagrees with the concept of using?discount rate manipulation to attempt to adjust for “risk,” we have not made an explicit change to our valuation model due to the presumed decrease in balance sheet uncertainty.
Back-of-the-Envelope Valuation
Making the changes to our assumptions mentioned here and assuming that share count is decreased by $50 billion worth at today’s price, we find very little change to our end valuation. Our original equally-weighted fair value estimate (weighted between best- and worst-case valuations) was $35 / share. Under the assumptions mentioned here, this falls slightly to $32 / share–a difference of less than 10%. For day traders, 10% is a lot, but for this investor, it is well within the “horseshoes and hand grenades” line (especially given the many unknowns at this point), so without further information or evidence to the contrary, I see no reason to change my present view on GE.