A GE Breakup Idea to Blunt EPS Fears

(Bloomberg Gadfly) -- What's in a number? For General Electric Co., maybe too much.

Back in 2015, fresh off the announcement that it would part with the bulk of its gargantuan lending and real estate operations, GE laid out a framework for its remaining businesses that suggested the company could reach $2 in earnings per share by 2018. Nelson Peltz's Trian Fund Management upped the ante later that year, arguing at least $2.20 in EPS was possible as it largely backed management's strategy of cost cuts and simplification.

GE has stuck by its $2 EPS forecast even as plunging crude prices and weak industrial demand pressured revenue and made analysts increasingly skeptical. That stubbornness created a will-they-or-won't-they albatross that's distracted from GE's transformation efforts, especially lately with the odds look increasingly against it. CFO Jeff Bornstein told a Barclays conference last week that changes in accounting rules may shave about 5 cents off EPS in 2018. GE subsequently said the $2 goal is still intact, but there was no mention of it in CEO Jeff Immelt's annual shareholder letter on Monday. Immelt called for "strong double-digit EPS growth," which could mean $2 but it could also mean less than $2.

Sanford C. Bernstein & Co. analyst Steven Winoker estimates that GE now needs close to 12 percent in annual industrial earnings growth (excluding the acquisition of Alstom SA's power assets) to reach its goal. That's going to be a stretch.

There's something to be said for holding GE accountable for what appears to be a pattern of overpromising and underdelivering. But even if that $2 EPS goal has to be rolled back -- and if it's going to happen, sooner would be better than later from a messaging standpoint -- there are other levers GE can pull to lift its valuation toward the $40 range targeted by Trian.

After all, Trian wasn't really focused on revenue growth to pump up EPS. Consider its core arguments: 1) GE should do more to improve its margins, 2) GE shouldn't overpay for dumb deals, and 3) GE should make its capital structure more efficient and take advantage of its newly expanded debt capacity.

GE is already working on cost cuts.  As far as the second point, GE craftily avoided writing a $30 billion takeover check for Baker Hughes Inc. by instead combining its oil and gas unit with the oilfield services provider in a new, publicly traded entity of which it will own 63 percent. That structure may also help the industrial giant make progress on Trian's third objective, albeit in an unorthodox way. 

Trian envisioned GE boosting its valuation by tapping into its debt capacity and using the proceeds to buy back shares. GE returned $30.5 billion to investors through dividends and share repurchases last year. But there's another way to change its leverage profile: namely, separating itself more definitely from the new Baker Hughes.

It seems more and more like that's something GE is preparing for. GE isn't guaranteeing Baker Hughes' existing debt, and, at the Barclays conference last week, CFO Bornstein suggested additional leverage that may be needed for the oil and gas business would likely land on the newly formed company's balance sheet, rather than be housed inside GE. That's a weird way to do things if you plan on holding onto the Baker Hughes business forever, notes Bloomberg Intelligence analyst Joel Levington. 

The Baker Hughes deal offers $1.6 billion in synergies and fills out the holes in GE's oil and gas portfolio, creating an oilfield-services and equipment company to rival Schlumberger Ltd. Should that business be spun off after the energy market recovers, it would likely command a multiple closer to Schlumberger, which trades at about 24 times its estimated 2018 earnings, compared with 15.5 at GE. As for what remained at GE, the stable and high-margin business mix would start to look a bit more like 3M Co. or even a Danaher Corp. Those companies also trade at higher valuations than GE.

So in theory, a bigger breakup with the energy business could lift the price part of the price-earnings equation. And at that point, maybe $2 in EPS isn't so important after all.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Brooke Sutherland is a Bloomberg Gadfly columnist covering deals. She previously wrote an M&A column for Bloomberg News.

1. The EPS goal was mentioned in Immelt's letter to shareholders last year. 

2. In December, the company announced a billion cost-cutting program it says can help it get to a percent-plus industrial operating margin by

3. When the deal was announced, GE executives said that the Baker Hughes transaction doesn't preclude a later spinoff of the oil and gas business and in some ways, makes it easier to structure something like that. 

To contact the author of this story: Brooke Sutherland in New York at bsutherland7@bloomberg.net.

To contact the editor responsible for this story: Beth Williams at bewilliams@bloomberg.net.