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Stocks  | January 28, 2019

Since new leadership took over General Electric (GE) late last year, there has been some anticipation that management would be making some major changes with the enterprise in order to restructure the business, pay down debt, streamline operations, and focus on creating value for investors in the long run. In its latest move, management has effectively found a way to generate more cash for the enterprise that can be geared toward this debt reduction as it seeks to effectively unwind its Transportation business, but it is worth mentioning that this maneuver is not without certain costs to the firm’s shareholders.

A Look at the Headline

In a press release issued on January 25th, the management team at General Electric announced that it would be changing how it is effectively removing its Transportation business (a set of operations centered in large part around manufacturing, servicing, and selling locomotives) from its other existing operations. According to management, the company will now no longer have a majority ownership over the combined entity that will consist of its Transportation business and Westinghouse Air Brake Technologies (WAB), or Wabtec.

*Taken from General Electric

Under its prior arrangement, General Electric had planned to merge Transportation with Wabtec, leaving Wabtec’s shareholders with 49.9% of the enterprise. General Electric, meanwhile, would receive $2.9 billion in cash, plus retain 9.9% of the combined company’s shares, and General Electric’s shareholders would receive, through a tax-free spinoff, the remaining 40.2% of the business. The hope behind this transaction was to effectively separate a viable but under-focused entity from the whole so that a separate management team could still run operations, while keeping a majority ownership for General Electric’s investors, all while receiving a sizable cash payout that could be used toward debt reduction and/or general operations.

Now, though, the picture is quite a bit different. In accordance with its newest filings on the matter, General Electric will still receive the cash payment (technically $2.885 billion), but the ownership percentages between all parties will be different. Wabtec, for instance, will see its ownership rise from 49.9% to 50.8%, giving its shareholders the lion’s share of the business. Though this change by itself may not seem significant, for General Electric’s investors it is. This is because, as part of the transaction, General Electric’s investors, since they will not have a controlling stake in the enterprise, will receive any spinoff shares in the form of a taxable dividend.

While individual shareholders will be worse off in this respect, the actual impact to them (through the value transfer to General Electric) might actually end up being better. This is because the allocation of ownership between General Electric and its investors of the new combined transportation firm will change in an interesting way. Instead of General Electric’s shareholders receiving 40.2% of shares through an effective spinoff, this number has now been reduced to 24.3%, and according to the data we have today, this will translate to around 1 share for each share of General Electric outstanding today. General Electric, meanwhile, will see its stake in the firm rise from its initially-planned 9.9% to 24.9%. In the table above, you can see the difference between how the transaction looks today and how it looked initially.

Digging in Deeper

At first glance, this transaction looks fairly simple, but it’s actually one of the more complex ones I have ever seen outside of the pipeline space. Sifting through its filings on the matter, I was able to create the following table below, which illustrates what all should transpire on the share side of matters.

In addition to receiving the cash component of the deal worth $2.875 billion, General Electric will contribute its Transportation assets to a new entity dubbed SpinCo. SpinCo, in return, will give to General Electric 8.7 billion of its own shares of common stock. In addition, it will issue to General Electric 15,000 Class A Convertible Preferred shares, 10,000 Class B Convertible Preferred shares, and 1 Class C Convertible Preferred share. None of these Preferred shares have any voting rights, only economic interests and certain other rights.

Both the Class A and Class B shares have a value of $1,000 apiece, for $25 million in value. They will both pay out to their holders an annual amount equivalent to 3-month LIBOR (currently 2.79% on an annual basis), plus 4.7% for an effective distribution of 7.49% per annum as I type this. Judging by what I read, General Electric will keep the Class A shares, but will immediately sell the Class B ones to Wabtec in exchange for $10 million, bringing cash consideration for this entire merger up to $2.885 billion. Any time after the 7th anniversary of the merger’s completion, the combined company will have the right to redeem these two classes of shares in exchange for their full par value. The Class C share, meanwhile, will be transferred to Wabtec in exchange for 10,000 Convertible shares that will be equivalent to 15% of the new merged entity, plus a right to receive another 9.9% of the shares of the combined entity (with 15% + 9.9% = the 24.9% of shares General Electric stated it would get).

I could not decipher a reason for the Class A and Class B shares to exist given how little value they represent, but I believe it has something to do, likely, with checking the boxes from a tax and regulatory side. Either way, for General Electric’s investors, it won’t matter in the end because the company’s time with those shares will be short-lived. In addition to selling the Class B shares immediately, it will either have to convert or sell the Class A shares within three years because, if everything goes according to plan, management needs to have divested all of its shares in the combined business, including the Class A units as though they were converted, in that time frame.

You see, according to the filings provided, during the first 30 days following the merger, no share sales may occur, but between the expiration of that lock-up period and 120 days following the merger’s completion, General Electric must own between 14.9% and 19.9% of the economic interest in the combined firm. By the end of year one following the deal, their maximum ownership cannot be higher than 18.5%, and by the end of year three the company must have divested all of its shares in the firm. Likely, this will take place through open market sales.

By selling off the stock, General Electric will be able to generate some cash, which is a positive, but it will mean no longer having an interest in a really attractive asset that has started to recover from a down cycle. Following the decline in Wabtec’s shares following the announcement, my estimate is that General Electric’s equity in the combined firm (excluding the 24.3% that General Electric’s investors will receive in a spinoff) will be worth about $3.24 billion. Without factoring in any possible taxes on General Electric’s side, this sale, combined with the cash component received, will result in total cash received by the firm of $6.125 billion. This is about $1.926 billion higher than what the company would have received by selling off all of its shares under the prior arrangement and assuming the same share prices applied.

Takeaway

Based on the data provided, it looks quite clear to me that the management team at General Electric has made a deliberate decision to reduce the stake in a spinoff that its investors will receive, plus to saddle them with a taxable distribution for what they will get. While this may make some investors feel like they are getting the short-end of the stick, I don’t necessarily see it as being all that bad. The extra cash received from the move, for instance, will provide extra fuel for the firm as it restructures, allowing it to reduce debt if it so desires. At the end of the day, the health of the broader conglomerate needs to be prioritized, because without it shareholders will only lose in the end.


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