We’re not General Electric (NYSE:GE) shareholders at Avondale, but it is a company that I have followed over the years. As a former bank analyst, GECC is a division that I have always made special note of during that time. The company’s decision last week to substantially wind down the operations of its capital division is a big one.
I just went through the conference call that the company held last week and even though many people seem to like the deal, I’m having trouble seeing how the numbers work out to generate value for shareholders.
Here are some notes:
1) This is a big hole to fill: GE Capital’s operating earnings were $7 Billion in 2014, or 42% of the company’s total. The company will be retaining part of GECC after these dispositions and has said that it expects the remaining piece of GECC to earn about $1.5 Billion run rate. That means that the company is walking away from $5.5 Billion in earnings.
2) In exchange for giving up those $5.5 Billion in earnings, it looks like the company will generate about $55 B in cash. (Note, the company is claiming $90 B in capital return, but $35 B of that appears to be dividends from the core business). Management expects to use this cash primarily to buy back shares. The important number to focus on is the pro-forma share count after buybacks, which management expects to be 8-8.5 B in 2018, down 15-20% from current levels.
3) Based on the current earnings of the industrial business and the leftover GECC earnings power, the “new” GE would earn ~$11 B today on a pro-forma basis. Even on a share count of 8 B, that’s only $1.38 in operating EPS, compared to $1.65 in 2014. That means the deal is not accretive to EPS and that instead of trading for 16.7x trailing operating earnings, GE is now trading for 20x pro forma earnings.
4) GE’s management says that the company will still earn the same amount per share in 2018 as it would have otherwise, but with better quality of earnings. The company is giving up 1/3 of its earnings power and only buying back 15-20% of its share count, so if the company is still going to achieve this, the industrial core will have to grow faster than it otherwise would have. It’s not clear how this transaction helps achieve that.
5) The reason that management gave for the disposition is that “we just did not see an attractive proposition for getting return on capital that made sense for the Company or make sense for shareholders.” That argument has big implications for the way that other financial services businesses are valued if you believe it.
6) However, management may have valued GECC at less than the market did. On the call, management said that they saw GECC as worth $75 billion. That’s 10-11x earnings and consistent with where other big financial institutions like Bank of America (NYSE:BAC) and JPMorgan Chase (NYSE:JPM) are trading. However, the difference between JPM and GE is that GE was probably getting a market multiple for its capital division. GE’s multiple on reported earnings is currently ~18x. Considering 42% of those earnings come from the capital unit, if that unit was only worth 10x earnings, it means that the industrial core was valued at 22x-23x. That’s about where 3M (NYSE:MMM) trades, so maybe that’s not so crazy on second thought…
7) Do financial services companies only deserve to trade for 10x earnings though? GE said that it couldn’t earn its cost of capital in financial services with an ROE of 8.6%, but what’s the cost of capital in a 1.9% interest rate environment? When everything else is selling for 20x earnings, an 8.6% ROE doesn’t look so bad.
8) Financial companies in general appear to be priced as if there is no long term franchise value above what’s on their books. This seems far from accurate. GE itself talked about the enviable market positions that it has in some of its lending businesses. From the call it sounds like the company will be focused on selling portfolio assets, not operating assets. If that’s the case then shareholders should consider that GE has destroyed serious value. What will become of the teams that achieved leading positions in middle market lending, equipment financing and the fleet services business? If they are simply laid off and competitors like CIT Group (NYSE:CIT) get to pick up the pieces, then GE shareholders have been done a major disservice.
9) Could GE’s decision actually be a contrarian sign that the worst is over for large financial services companies? GE doesn’t have a pristine record as a capital allocator under Jeff Immelt. In 2007 the management team steered the company hard towards clean energy (especially windmills) and emerging markets infrastructure investments. Both were hot ideas at the time which have since lost luster. Since 2011, the company has spent billions of dollars on acquisitions in another hot sector, oil services, including a $3 B purchase in April of 2013 just as the price of oil was peaking. So, just because GE says that returns on capital in financial services won't recover doesn’t necessarily mean that they’re right. In fact, recently the company has had a track record of being wrong.