Billionaire activist investor Nelson Peltz made headlines yesterday when his $12 billion hedge fund, Trian Partners, took its largest position ever -- a $2.5 billion stake -- in General Electric , making the fund a top-10 owner of the stock. Shares of GE closed up over 5% on the day, suggesting the market applauded Peltz as a welcome development.
Trian released an 81-page white paper detailing why General Electric is undervalued and could be worth between $40 and $45 per share by the end of 2017, including cumulative dividends. Based on yesterday's closing price, it implies Peltz believes GE stands to gain between 50% to 68% in about two years' time.
The fund's underlying thesis hinges on the belief that investor skepticism toward management, caused by long-term underperformance of General Electric's stock, has created a mispriced security, and the transformation that GE is currently undergoing is underappreciated. Trian even titled the white paper "Transformation Underway... But Nobody Cares."
Peltz and Co. do not have any current plans to join the board, shake up management, or drastically change the course of GE's massive transformation into a streamlined digital industrial company freed of operating a capital intensive financial services business that was burdened by regulatory oversight. Instead, Trian's investment holds GE's management more accountable to execute on its plan and endorses the company's return to its industrial roots as the right move.
In the white paper, Peltz outlined three major areas that contribute to GE trading at $40 to $45 per share by the end of 2017.
The first is expanding GE's overall EBIT operating margin from 14% in 2014 to at least 16% by the end of 2018, and then eventually to 18%, by focusing on cost cutting at the input and operating cost levels. Trian argued that GE's industrial operating margins are about 260 basis points below its historical average between 2004 and 2014, suggesting there's likely room for improvement.
The second area is to improve GE's capital structure further by taking on an additional $20 billion in debt by 2018, returning the raised cash to shareholders in the form of increased buybacks, and further reducing the size of GE Capital's balance sheet. Although taking on $20 billion in debt may threaten GE's current AA+ rating from S&P, Trian thinks the company would likely still maintain a high investment grade rating.
Trian also asserted that "moderate leverage can alleviate pressure on the income statement and allow management to reinvest in the business." To be clear, this view is at odds with what CEO Jeff Immelt said in May at a conference -- that the company likely wouldn't need to issue new debt for approximately another five years. Immelt did, however, caveat that it may reconsider its stance on debt issuance once GE Capital is no longer considered a systemically important financial institution by government regulators.
Finally, Trian believes General Electric's management should explore share repurchases over and above the $50 billion buyback plan it announced in April, which will run through the end of 2018.
Putting it all together
If GE executes to plan, Trian estimates the company will earn $2.23 per share in 2018 and trade at a 10% to 25% premium over the S&P 500 at the close of 2017:
What's more, the investment company thinks GE can return up to approximately 40% of its current market cap -- $110 billion -- in the form of dividends, stock buybacks, and share exchanges by the end of 2018. GE's plan is to return $90 billion -- about 33% of its market cap -- in the same timeframe. The biggest difference between GE's and Peltz's plans is that GE's plan isn't taking into account an additional $20 billion of debt for more buybacks.
Given that Trian will be taking a more passive position that holds management accountable for executing its transformation, it doesn't seem likely the hedge fund will fret much over its proposed debt issuance to fund additional buybacks. Of course, that could change if GE doesn't execute on its plan to drive 90% of its earnings from industrial activities by the end of 2018.
After all, Peltz has a reputation of enacting change.
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The article Nelson Peltz's $2.5 Billion Bet on GE: What Investors Need to Know originally appeared on Fool.com.
Steve Heller has no position in any stocks mentioned. The Motley Fool owns shares of General Electric Company. Try any of our Foolish newsletter services free for 30 days . We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy .
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