2015-09-11

Summary

After a year and a half of wrangling with the European Union, GE’s acquisition of Alstom’s energy business should finally close in the next few weeks.

Leaks over the summer have turned out to give us fairly solid clues as to what concessions the E.U. would extract. They are not terribly punitive.

GE is gradually accomplishing the restructuring it has set out to do. Closing the Alstom deal is another important step along the way.

GE should be bought for 15-20% outperformance on a one- or two-year view.

Reuters reported last Friday that the European Union would approve General Electric’s (NYSE:GE) $13.8 billion acquisition of the power generation and network businesses of Alstom S.A. (OTCPK:ALSMY) at a meeting on Tuesday. This duly occurred; U.S. approval is expected to follow immediately and it is possible that the deal will close by the end of the month. This brings to a close a long, picaresque saga that began in April last year, which featured a variety of entertainment, including the French government soliciting competing bids, reversing itself and supporting the deal against very considerable E.U. skepticism, and now, at last, a deal. It will be GE’s largest acquisition ever.

Obtaining precise details on what it is that GE will be buying is difficult, since the E.U.’s agreement to the deal comes with conditions attached, not all of which are easy to dissect and value. Further, Alstom relegated these business to “discontinued operations” in its fiscal March 31 annual report, thereby economizing on disclosure. What it did say about them is not so easy to compare with GE’s disclosure, but a 3.4% pretax margin is not especially encouraging:

€ millions

Year to March

31, 2014

Year to March

31, 2015

Revenues

14,332

13,330

Pre-Tax Income

673

454

GE does not break out segment pretax income, but assuming rather arbitrarily that corporate and interest charges are distributed across GE’s operations proportionately to their contribution to operating income, GE’s Power and Water division achieved pretax margins in the vicinity of 13.3% on revenue of $27.6 billion in calendar 2014.

Even while it has been swearing itself blind that no E.U. (and especially no French!) jobs would be at risk from the transaction ─ in fact, it has committed to adding 1000 jobs in France ─ GE’s forecast of expected cost savings over the next five years from combining its power operations with those of Alstom has doubled to $3 billion from its original estimate. Naturally, GE has offered few details as to how this is likely to be achieved, but it might not be a good time to be buying real estate in Schenectady.

Background

Since the Second World War, Alstom has been something of a plaything for France’s economic planners. In the 1970s, it had Chantiers de l’Atlantique thrust upon it, presumably in the hope that a maker of turbines could turn around a shipbuilder at precisely the time that ships were abandoning turbines for more fuel-efficient diesels. Not surprisingly, the shipyard was unable to overcome Japanese and eventually Korean and Brazilian competition. Alstom was at last able to extract itself from this arrangement in 2010.

Meanwhile, Alstom was folded into the Compagnie Générale d’Électricité conglomerate, along with a variety of other disparate businesses, including the former ITT telephone switch manufacturer, which was the predecessor of what eventually became Alcatel-Lucent (NYSE:ALU). This arrangement among strange bedfellows was dissolved in 1998. Alstom nearly went bankrupt in the early 2000s, as the consequences of building standard ships with a European workforce became especially apparent in a market downturn, and as a result of expensive design flaws it had inherited from its joint venture with and eventual acquisition of Brown Boveri’s (latterly ABB’s (NYSE:ABB)) turbine business in 1999. It received a € 2.3 billion bailout from the French government, and was required by the E.U. to shed a variety of assets. In what seems suspiciously like a case of parking these assets with friendly owners, it re-purchased some of them a few years later.

Alstom’s power business has spent the subsequent period attempting to build its presence in developing country markets and expand into renewables. In this it has been reasonably successful, although the success has not translated into a strong recovery in its financial performance. U.S. Foreign Corrupt Practices charges alleging improper payments on power contracts in the Bahamas, Indonesia, Taiwan, Egypt and Saudi Arabia over more than ten years, to which Alstom pleaded guilty, accepting a $772 million fine, suggest that perhaps some of this success was not on its products’ merits. The sale agreement specifies that none of the costs of this record fine will be passed on to GE. Alstom gradually came to the conclusion that it lacked scale to compete in the turbine business in particular, where development costs continue to mount and where its location in the low-growth European environment, overshadowed by the much stronger Siemens (OTCPK:SIEGY), has not been helpful.

Alstom’s Contribution to GE

The deal brings GE’s capabilities that it had previously lacked in renewable energy and heat recovery steam generators. The latter are key components of combined cycle gas-plus-steam plants, which GE forecasts will account for 70% of future gas-fired plant orders. Acquiring this capability roughly doubles the General Electric share of the revenues it could capture from orders for such plants. With it comes considerable expertise in plant design and construction, allowing GE to move from being a supplier to a lead contractor on such projects. Alstom also delivers significant presence in China and India, as well as sophisticated products in transmission technology, although in these cases there is overlap with GE’s existing power business.

Alstom increases GE’s installed base of steam and gas turbines by 35% in terms of gigawatts. Service contracts on such high value, mission-critical capital goods are lucrative ─ or can be. In its discussion of the deal, GE has singled out for attention that Alstom achieves only half the margin on service that GE is able to capture, and indicates that it expects to be able to bring those margins more closely in line with its own. To me, at least, so large a differential suggests either that: 1) GE is not talking about the same thing that Alstom is talking about, when it discusses services; and/or 2) there may be some problems with Alstom’s service business.

1) Alstom discusses servicing thermal plant in the context of “Service and Retrofit.” Obviously, retrofit is something other than just routine maintenance. It is not clear how GE categorizes retrofit. Note that retrofit is especially relevant to the problems Alstom had with the Brown Boveri turbines. Gas turbine plants may also be retrofitted as combined cycle plants.

2) Over time Alstom has bought several turbine manufacturers in addition to its ill-fated purchase of ABB’s operation, including a fairly large business from GEC (the defunct U.K. firm), and the cost of servicing numerous designs is inevitably higher than servicing a single product line.

Services of all types (not just on thermal turbines) account for 48% of GE’s Power and Water revenues and 83% of its order backlog (given the cost of shutting down much of this sort of equipment for maintenance, service is scheduled years in advance). So getting this right is obviously crucial to the success of the transaction. The concessions GE has had to accept to get the deal done include transferring to Ansaldo Energia (privately held; 40% acquired by Shanghai Electric Group this year) service contracts on 34 of Alstom’s large and very large turbines as well as an American servicing unit, Power Systems Manufacturing LLC, that Alstom purchased in 2007. The latter boasts roughly $90 million in revenues, primarily obtained on contracts to service GE turbines. It also has, at least historically, captured very strong margins. This presumably leaves GE with the less profitable portion of Alstom’s servicing business.

GE will also provide Ansaldo with the intellectual property to build Alstom’s GT-24 and GT-26 gas turbines. Ansaldo has historically licensed its gas turbine technology from Siemens, so this is something of a coup for it ─ these are designs that have achieved reasonably good market acceptance. But it is not a great loss for General Electric, because the engines’ fundamental design philosophy is so different from that which GE and Siemens employ in their competing products that it is unlikely that GE would have continued manufacturing them.

Deal Synergies

GE has said that it expects the deal to be accretive to EPS by $0.06 – 0.09 in 2016 and $0.15 – 0.20 by 2018. Ultimately, it expects to achieve $3 billion in cost savings and synergies from Alstom. The near-term accretion should be fairly easy to achieve: by a very rough calculation, Alstom Energy earned the equivalent of $0.05 per GE share outstanding in its fiscal year to March 31 2015. The last quarter of 2015 can be used to begin to put the most immediate synergies in place, probably to do primarily with head office costs. Like all darlings of the French state, Alstom enjoys a high cost Paris headquarters and an ample, rather cosseted administrative staff. GE has presumably negotiated to leave as much as possible of this with Alstom’s transport operations, which it is not buying.

Apart from the GT-24 and GT-26 models discussed above, GE is likely to continue manufacturing and marketing only one or two of Alstom’s gas turbine designs, most notably the GT13E2, an unusual design which has a market niche in Russia and the former CIS countries. What is to become of the designers and builders of Alstom’s other turbine products is not obvious, but the terms of the transaction make it quite clear that their immediate fate will not be to come off the payroll. With luck, Ansaldo may want to hire some of them: in particular, there is a research facility in Switzerland that they are quite likely to want to purchase.

It probably would not hurt GE’s operations to diversify some of its production costs to the Eurozone, but converting Alstom turbine manufacturing facilities to GE product designs will involve a learning curve before they can become as efficient and reliable as GE’s existing capacity. However, GE only entered the market for the very largest turbines with the launch of its 9HA model in March last year. This is a segment in which Alstom has been active much longer, and sixteen months probably has not allowed GE’s U.S. plant to climb so very far up the learning curve that Alstom’s plant cannot catch up.

The longer-term forecast of $3 billion in savings is ambitious, given that it assumes savings of nearly 7% of the combined operations’ revenues. It probably entails that GE will be able to capture more or less all of Alstom’s global market share for new orders and service contracts. But in addition to bribery, Alstom presumably offered a product that customers preferred over those offered by its competitors, including GE. Why customers who previously turned their noses up at GE’s products would change their minds, given that Alstom’s designs will still be available from Ansaldo, is not immediately clear. Further, Ansaldo’s connection with Shanghai Electric Group certainly cannot hurt its market chances in China, which will remain, regardless of economic slowdown, the world’s strongest market for both thermal and hydroelectric equipment.

The timing of the deal is likely to prove helpful to GE. Demand for power equipment has been recovering gradually from over the last few years, but orders are still well below their 2007 peak. The recession has depressed growth in electricity demand, relieving some of the pressure for utilities to invest, but this will not last forever. Nor will the equipment that has already been installed. There is a cycle in the purchase of electricity generating equipment as there is for most other capital goods, which the crash has to some extent suppressed, but utilities will have no choice to invest eventually.

Even though this is the largest acquisition General Electric has made, the company has considerable experience integrating companies and imposing its financial disciplines on them. It is not being unduly pessimistic to note, however, that a jewel of the French industrial crown is a rather different matter than most integration challenges. A company such as GE, with its passion for lean management structures and tight cost control, may be in for something of a cultural shock. Given the sensitivities on all sides ─ government, management, labor force and customers ─ GE will certainly have its work cut out for it. At least Jeffrey Immelt has not proved as ham-fisted as his predecessor in dealing with European sensitivities.

Analysts have generally been positive about this transaction, and I think justifiably. Along with a number of important divestments, it represents an important step in the transformation of General Electric from a financial services firm with a sideline in manufacturing to a more or less purely industrial company. It gives GE an extraordinarily strong global position in a market that offers growth and significant rewards to the type of engineering innovation in which GE excels. It would be foolish, however, to think that capturing the potential of the Alstom acquisition will not be a considerable challenge.



General Electric has been a mediocre performer over the last year. This seems a bit unjust, given the substantial progress it has made in its reorganization. Granted, there is still more progress to be made, and in particular, finding a buyer for its appliances division is likely to be a challenge given the Justice Department’s remarkable opposition to the Electrolux (OTC:ELUXF) (OTCPK:ELUXY) bid. But the acquisition of Alstom’s energy businesses is potentially transformative. I believe that General Electric should be bought on a one- to two-year view and an expectation of 15-20% outperformance.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

Disclosure: I am/we are long SIEGY. (More…)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.

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