General Electric (GE) has reportedly filed confidentially for an IPO listing, after announcing its intention to separate its healthcare division into a standalone company this past summer. The company gave a timeline of 12 to 18 months in June of 2018 which would lead to a possible IPO between June to December 2019. Now that the process has started, is it worth buying the IPO? What about GE itself after the spinoff? Here are things to consider.
Under GE, the healthcare business line has actually been profitable with growth rates in the single-digit range of 4.5% in 2017 and 3.6% in 2016. This might not seem all that exciting, but the key is that GE has been having success in emerging markets which is a good sign because these countries have higher GDP growth rates than the developed nations such as the United States. The healthcare business unit accounts for about 15% of the total revenue for GE but contributes about 27% of the positive operating income generated.
Meanwhile, GE has a host of businesses that it's discontinuing which are operating at a loss, making them non-viable entities. So why spin off the healthcare division? In order to generate much-needed cash along with the company shedding business lines which do not have above average revenue growth. It needs to pay off debt, and fast, before interest rates rise substantially.
The healthcare industry which this business unit competes in is dominated by McKesson (MCK), UnitedHealth Group (UNH), Amerisource Bergen (ABC), Cardinal Health (CAH) and CVS Corp (CVS) which are the top five players making up about 25% of revenues in a $3.31 trillion-dollar market. The GE Healthcare unit only makes up only 0.57% of those revenues which serves as a potential growth opportunity for the spin-off if it can grab more market share.
As of Sept. 30, revenues were flat from the previous quarter for the unit while profit was up 2%, driven by cost reduction due to increasing digital automation, logistical changes, restructuring, and higher volumes. Year over year, revenues are up 5% with profits up 8%, indicating higher efficiency, a good sign going forward. There's a pricing headwind that the company is experiencing, but this is somewhat reflected in its single-digit growth range and is typical for a mature industry.
When GE spins off this company, the new entity will probably be profitable from day one, but it will be a smaller cap name which might inhibit its ability to borrow capital at reasonable rates. As of last December, the unit had about $3.448B in operating income which derived from $19.1B in revenue for an 18% operating profit.
While none of the top five businesses mentioned above are exactly alike, Cardinal Health can be used as a proxy because it provides a conservative expectation for what the company might look like after being spun off.
Return wise over the past two years both GE and Cardinal have struggled, with these companies posting returns of -78% and -40%, respectively, during this timeframe. While this looks bad, Cardinal Health is still one of the top five companies in the healthcare distribution industry, and other than UnitedHealth the other top companies have had lackluster stock returns during the past two years as well. Cardinal Health has been profitable for the past couple of years and its growth rate resembles one of a mature company in a mature industry with an expected growth rate of 5%.
The profit margins for the GE spin-off might be better, estimated to be about 18% in the current structure, while Cardinal has a current operating income margin of only 2.6%. This of course is pending the debt load and pension expense the new company might take from GE’s books, which is part of the point, since GE cannot keep its current debt load and survive. None of the top five have double-digit profit margins, but UnitedHealth Group stands out from this group because it has long-term growth of around 12%. For investors looking for an alternative to UnitedHealth Group with lower growth but a quality balance sheet, this spin-off might be a viable option.
For GE, this event creates a source of cash that the company can use to pay off debt, but the negative obviously is that they will spin off their second-highest revenue-generating business unit, making it even harder to pay back the debt that remains.
Despite spinning off the healthcare unit, GE still has the legacy headache, GE Capital. This group is a significant problem for GE because it has the most amount of assets, but the business unit is the biggest drag on the firms’ financial resources with significant losses during the past three calendar years. On a pre-tax basis, the income from the aviation department which is the highest revenue generating business unit for GE was offset by the losses from GE Capital during 2017. While the spin-off will help to boost the growth rate of the firm and possibly firm valuation/market value, GE will not be solving all of its problems in one fell swoop by far, but instead will only be kicking the can down the road. This momentary boost is positive for the firm, but it will probably not be enough to boost their dividend nor make it sustainable.
As a spin-off, the GE Healthcare unit can be a viable standalone company, but timing does not look to be on its side. Doing an IPO at the tail end of this 10-year bull run that's arguably already over could be a significant hindrance for its stock price. Almost all major domestic US indices are in bear market territory and it's increasingly likely that we are headed toward a recession, possible even at the very time that the IPO officially happens.
The IPO market is binary with more misses than hits, and unfortunately GE will be doing this spin-off facing market headwinds that will be against it. While the company should be viable, buying it once it goes public might not be a wise option, but it's a "watch and wait" because returns are highly likely to struggle out the gate due to the management team getting accustomed to managing market expectations and the current turbulent market environment.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.