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Why GE's big transportation deal provides little help on debt

General Electric Co. clinched its biggest deal since John Flannery took over as CEO in 2017 — the spinoff and merger of GE Transportation with Westinghouse Air Brake Technologies Corp. in a transaction valued at $11.1 billion — but getting its debt down to a manageable level may still prove challenging.

The combination of GE Transportation's locomotive engine unit with the Westinghouse railroad equipment business, known as Wabtec, was good the latter as its stock jumped 6% on the May 21 announcement to a high for the year of $100.28.

Investors seemed less sure about the benefit for GE and its ability to take care of its shareholders and remain in the good graces of rating agencies by reducing its debt pile. GE's shares gained 3.5% on the news to close at $15.26 but are still down about 45% for the year.

As of the first quarter, GE had $125.8 billion of debt outstanding, or net debt/EBITDA of 7.2x, according to data compiled by S&P Capital IQ.

Last month, Moody's Investors Service changed GE's outlook to negative, while affirming its A2 rating, and said the company's ratings could be downgraded if it did not continue to make progress in lowering debt/EBITDA toward 2.5x, "including as a result of the deployment of proceeds from planned divestitures solely for share repurchases."

Pension liabilities remain

Some analysts suggested the Wabtec deal might not move the needle on debt deleveraging.

"The need to do more to raise cash to [satisfy] the ratings agencies and move toward 2.5x [leverage] remains the elephant in the room, for which we see future dilutive transactions in store," JP Morgan analyst Stephen Tusa wrote in a note after the deal announcement.

Noting that GE was retaining most of the pension liabilities from GE Transportation rather than shifting them to the new joint company, Tusa wrote that "from a de-levering perspective, it appears credit negative in the context of our 2018 [estimated] debt/Ebitda calculation which remains about 4.7x."

The deal's complex structure makes it hard to determine how much benefit will be realized by shareholders and how much will be available to help pay down GE debt, analysts said. The agreement creates a new company, with GE owning 50.1% and Wabtec owning the rest. GE's stake in the entity is further split 40.2% to shareholders and 9.9% to the company. After a standstill period, GE is obligated to sell off its stake in three years.

Chief Executive John Flannery was careful to emphasize that GE would "take a $2.9 billion dividend on Day 1" when talking about the deal at an industry conference a few days later.

Still, the need to protect shareholders through a tax-free structure materially lowers the amount that would be able to reduce debt, Moody's said. The rating agency also calculated that the free cash flow that could go toward debt reduction would be reduced by at least $450 million because of the structure.

Yes, $5.4 billion helps

Still, Moody's said it expected the $2.9 billion upfront payment plus tax benefits to yield aggregate proceeds of $5.4 billion "using a pro forma equity value of the combined company of $20.5 billion."

"The estimated $5.4 billion aggregate proceeds that GE would realize from the GE Transportation divestiture would augment GE's cash balance, enabling the company to repay a considerable amount of debt and/or reduce its pension deficit," Moody's noted.

Tusa was not as optimistic about the company's valuation for the Wabtec deal, noting that most of the value to GE was based on expectations of the new company's performance in 2019 — the deal is expected to close early next year — and "a less-than-balanced view of industry potential (25% Ebitda increase)," he wrote.

In a bid to fill its coffers and address its debt load, GE also said in April that it sold its healthcare information technology business to Veritas Capital for $1.01 billion. Its Alstom power unit also has about $3 billion in redemption rights for various joint ventures, Moody's noted.

GE still has problems in GE Capital, the company's captive finance unit. GE reportedly is trying to sell its long-term care insurance business, for which it had to set aside $15 billion over the next several years to cover losses after a long period of low rates held down its returns on invested dividends. Though a rising rate environment should help that situation, "the risk is that GE Capital's value goes negative or it requires a cash infusion from the parent," Gabelli & Co. analyst Justin Bergner wrote in a research note.

GE Capital also has a subprime mortgage portfolio left over from its now-defunct WMC Mortgage Corp. for which it has set aside a $1.5 billion reserve to address potential legal liabilities.

When asked about disposals for the insurance business at the industry conference, Flannery said GE was moving in a "deliberate and thoughtful way."