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America’s Economic Collapse


Could General Electric Collapse?

November 17th 2008

Corporate Logos - General Electric

General Electric, the legendary American institution, founded in 1878 by Thomas Edison, is in deep trouble. Its PR machine has been in constant spin mode as the company sinks deeper into fiscal despair. GE is one of the few major companies in the U.S. that still retains an AAA rating. Considering Moody’s and S&P’s track record rating companies and financial instruments, not a few observers feel that an AAA rating is not worth the paper it is written on.

One look at GE’s balance sheet will convince an inquirer that the firm indeed does not deserve an AAA rating. AAA companies do not need to take the desperate actions that GE has taken in the last few months. Something is seriously wrong at GE.

The stock reached $53 at its peak in 2000 and has virtually crashed to below $17 this past week, the lowest level since the mid-1990s. CEO Jeffrey Immelt, who took over from icon Jack Welch in 2001, has made his mark by managing the company to a 68 percent decline in its stock price. No one at CNBC seems willing to take a hard look at GE’s financial statements or ask the CEO tough questions, because Mr. Immelt signs their paychecks. While shareholders have taken a bath, Mr. Immelt, a Harvard MBA, raked in $72.2 million of compensation between 2002 and 2007. A company that is known for its "pay for performance" mantra evidently does not hold its CEO to the same standards.

The first signs of cracks in this global institution appeared in April 2008. For decades, GE has failed to meet its earnings projections. It is widely known that the corporation is a master of "legal" earnings manipulation. Accounting rules allow for wide discretion in reserves and estimates. GE Capital has always been a black box within the larger company. GE does not provide detailed financial information about this division. This lack of detail has allowed GE to use this division as its backstop for meeting earnings estimates. During a better than expected quarter, the company takes extra reserves and uses them to have the quarter meet estimates—or beat them by one cent. During a down quarter, it uses those excess reserves to meet estimates. Conveniently, the GE Capital division would also sell liquid assets at the end of a quarter to guarantee smooth sailing. This earnings management had lulled analysts and stockholders into complacency regarding GE’s overall business health.

In mid-March, Mr. Immelt confirmed publicly that GE would meet earnings expectations of $.50 to $.53 per share for the quarter ending March 31. With 2 weeks left in a 12 week quarter, Mr. Immelt was confident in the results. When GE reported earnings of $.44 per share in early April, the world was shocked. Knowing that GE always has excess reserves to manage its earnings, with only two weeks left in the quarter, the magnitude of the earnings miss was beyond belief for many. The stock, which had reached a yearly high of $37, dropped 16 percent to $31.

Former CEO Jack Welch went on CNBC and said, "I’d be shocked beyond belief, and I’d get a gun out and shoot him if he doesn’t make what he promised now. Here’s the screw-up: you made a promise that you’d deliver this, and you missed three weeks later. Jeff has a credibility issue." Mr. Welch is absolutely right. Jeffrey Immelt has no credibility left. His excuse was, "We had planned for an environment that was going to be challenging... [but] after the Bear Stearns event, we experienced an extraordinary disruption in our ability to complete asset sales and incurred marks of impairments and this was something that we clearly didn't see until the end of the quarter." A top CEO should have a better handle on his business.

The next daggers into Mr. Immelt’s credibility occurred in late September and early October. On September 25, with the stock trading at $25.50, Jeff Immelt lowered GE’s earnings guidance and suspended its $15 billion stock buyback plan, but also declared the company needed no outside capital. He reaffirmed his commitment to maintaining a AAA rating with these actions. One week later he convinced Warren Buffet to invest $3 billion in the company by paying him an annual dividend of 10 percent while granting him warrants to purchase $3 billion of common stock at $22.25. GE then sold $12 billion of additional shares at $22.25 to the public. These were not the actions of a company or CEO that is in control. AAA-rated companies do not have to pay 10 percent interest rates. Credit default swaps protecting against GE Capital default traded as if GE is a junk bond credit.

The issuing of $12 billion in common stock at $22.25 per share is an act of extreme desperation and brings into question whether GE has a lucid strategy. How can investors have confidence in a company that bought back 97 million shares for $3.1 billion at an average price of $31.69 in the first nine months of 2008, and then issued $12 billion worth of stock at $22.25 in October? Not only did they buy back $3.1 billion of stock in 2008, but they also bought back $27 billion of stock in the prior three years at an average price of $36.46. This is a twist on the old saying, but GE is buying high and selling low. If Mr. Immelt was not so focused on trying to beat short term earnings goals by wasting $30 billion of cash on share buybacks, he wouldn’t have had to beg Warren Buffett for $3 billion last month at very poor terms from GE’s perspective. A CEO is responsible for preparing his company for a worst case scenario and should never risk the company in an attempt to meet short term goals. Mr. Buffett may have made one of the few mistakes of his glorious investing career. He has lost $762 million on his investment in 1½ months, a return of -25 percent.

Most people know GE as an industrial conglomerate that makes light bulbs, appliances, and jet engines. Its advertising agency has positioned GE as a "green" company with an advertising campaign called "Ecomagination", stressing wind power, hybrid locomotives, and environmentally friendly products. But it is easy to see why GE’s ad campaign should be called "Bankomagination." Truth: GE is actually a bank disguised as an industrial conglomerate. The GE Capital division truly dominates the results of the entire company.

Let’s look at GE Capital, which has three subdivisions GE Commercial Finance, GE Money, and GE Consumer Finance. In 2003, GE Capital generated $5.9 billion of larger GE’s $17 billion of profits, or 35 percent. By 2007, GE Capital was generating $12.2 billion of larger GE’s $29 billion profits, or 42 percent. Being a bank during the boom years of 2004 to 2007 did wonders for GE’s bottom line. Being a bank now is a rocky path to destruction.

GE Capital is enormously leveraged to consumers throughout the world. GE Capital provides credit services to more than 130 million customers, including private label credit card programs, installment lending, bankcards and financial services for customers, retailers, manufacturers and health-care providers. This massive portfolio is heavily concentrated in credit cards for Wal-Mart, Lowe’s, IKEA, and hundreds of other retailers throughout the world. Billions are tied up in debt consolidation to home equity loans. The division also owns 1,800 commercial airplanes, leasing them to 225 airlines worldwide. GE Capital has also been a huge benefit to the industrial side of the company’s business. GE Capital provides financing for customers that buy GE power turbines, jet engines, windmills, locomotives and other big ticket items.

The crucial question is this: can the people and companies who received loans from GE Capital pay them back? GE’s entire future is highly dependent on the answer to this question. But look at the trillions in global defaults towering throughout the industrial world.

The GE's AAA rating allows GE Capital to borrow funds at lower rates than all banks in the United States. Its cost of capital has been 7.3 percent. Losing that rating would be disastrous to GE Capital. Between 2002 and 2006, GE Capital did what most other banks did—they levered up. The company’s ratio of debt to equity rose from 6.6 to 8.1 during the heady years when profits quadrupled. Then, GE Capital jumped into the subprime mortgage market in 2004, buying WMC Mortgage. It sold the bleeding subsidiary in 2007, after racking up losses of $1 billion that year. It also unloaded a Japanese consumer lending company at a $1.2 billion loss that same year, 2007.

It is clear that risk management has taken a back seat to profits at GE Capital. GE Capital’s profits plunged 38 percent in the 3rd quarter, the main reason for GE’s earnings miss. Analyst Nicholas Heymann of Sterne Agee wrote: "Investors now understand that GE uses the last couple weeks in the quarter to 'fine-tune' its financial service portfolios to ensure its earnings objectives are achieved. It turns out, it really wasn't miracle management systems or risk-control systems or even innovative brilliance. It was the green curtain that allowed the magic to be consistently performed undetected."

Egan-Jones, an independent rating agency, calculates that by now, GE is levered ten-to-one, a more conservative and higher number than the company's own stated eight-to-one figure. Cofounder Sean Egan believes that, depending on the off-balance-sheet holdings, actual leverage could be still higher. His firm rates GE not with a AAA but with a single-A. Looking at GE’s Balance Sheet between 2003 and today, a deteriorating situation is clearly tracked. Long-term debt grew from $172 billion in 2003 to $381 billion by the 1st quarter of 2008, a 121 percent increase. Their long term debt to equity ratio grew from 68 percent to 77 percent. Short-term debt grew from $157.4 billion in 2003 to $218.7 billion in the latest quarter, a 40 percent increase. The 70 percent increase in profits between 2003 and 2007 were undoubtedly juiced by the use of prodigious amounts of debt. Stockholder’s equity is at the same level as 2004. With cash of only $59.7 billion and short-term debt of $218.7 billion, the freezing up of the credit markets has put GE at major risk when trying to rollover their debt.

All indications point to a company in trouble. Mike Shedlock, a brilliant financial analyst, recently quoted an insider at GE Capital. "Sales personnel are not allowed to make any more loans this year, and are being told to try to get their customers to pay off their loans. All prepayment penalties are waved for closing loans and GE Capital is about to launch a new incentive scheme for the salespeople that makes it worth their while to get their customers to agree to participate." This sounds like the actions of a company desperately trying to pay down debt. The risks and unknowns for this company are many.

GE announced plans during the summer to sell its lighting and appliance business. It expected to get $5 to $8 billion for these divisions. But it has found no buyers. GE announced that it wanted to sell its private label credit card business, with $30 billion of outstanding receivables. It is not surprising that no buyers have appeared for that business either, especially since it is widely known that many of these receivables are owed by subprime borrowers. GE does not provide bad debt figures for these portfolios. Paying Warren Buffett 10 percent on preferred shares when their cost of capital has been 7.3 percent is a sign of intense stress. GE has $74 billion of commercial paper outstanding that rolls over every few days. GE was rumored to be unable to rollover this paper. They are now utilizing the Fed’s short-term funding facility. This is a sign of weakness.

GE holds $53 billion of off-balance-sheet assets that are pieces of securitized debt, some of which are hooked to interest rate swaps with counterparties that are now troubled. The value of these assets is a complete unknown, but is likely to be worth far less than $53 billion. GE’s recent 10Q had the following disclosure: "GE Capital has exposure to many different industries and counterparties, and routinely executes transactions with counterparties in the financial services industry, including brokers and dealers, commercial banks, investment banks and other institutional clients. Many of these transactions expose GE Capital to credit risk in the event of default of its counterparty or client. In addition, GE Capital’s credit risk may be exacerbated when the collateral held by it cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the loan or derivative exposure due to it." Much of GE’s debt is covered by credit insurance. This insurance is virtually worthless, as the credit insurers have collapsed.

GE has $43 billion of long-term debt maturing by June 30, 2009, with another $38 billion due by December 31, 2009. The terms for refinancing this debt will be much worse than the previous terms. GE convinced the U.S. government to insure $139 in debt for GE Capital using the new FDIC program. Why does a AAA company need a government guarantee? Rumors of a dividend cut have been swirling in the business press. GE spokesmen have guaranteed the dividend only through 2009. Many other banks have promised no dividend cuts in the last year, only to cut dividends a month later.

The most hazardous unknown for GE is the global recession that will likely ravage the company in 2009. Their five main businesses (Technology Infrastructure, Energy Infrastructure, Capital Finance, NBC Universal and Consumer & Industrial) will all be under severe stress in 2009. Technology Infrastructure is dependent on airline and military spending. Airlines are struggling just to survive and conserve cash. The Obama administration is likely to reduce military spending dramatically. Energy Infrastructure is dependent on wind, oil and gas companies. With the spectacular decrease in oil prices, these companies are massively cutting capital budgets. Financing for large projects has dried up.

The conclusion are inescapeable. GE Capital is dependent on consumer credit, commercial lending & leasing, and real estate. This division will be overwhelmed by a tsunami of deleveraging in 2009. Consumers will be defaulting in record numbers and commercial real estate has just begun to implode. NBC Universal is reliant on advertising revenues from companies and consumer spending on entertainment. Every leading company in America will be reducing advertising budgets in 2009 and consumer discretionary spending is collapsing. The Consumer & Industrial sector is dependent on consumer’s spending money on appliances. A housing collapse has led to collapse in appliance sales, which will continue in 2009

The future does not look bright for GE. A perfect global storm will hit GE in 2009. GE is like a giant supertanker loaded with debt that is in danger of being swamped by this perfect storm. A collapse of GE, with hundreds of billions in supposed value, would not bring good things to life. It would bring about the mother of all bailouts.

Cutting Edge Financial Crisis Analyst James Quinn is a senior director of strategic planning for a major university. This article reflects his personal views, and does not necessarily represent the views of his employers and is neither sponsored nor endorsed by them.

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