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October 1, 2008 2:35PM

What Buffett May Be Missing at GE

By Elizabeth MacDonald

General Electric fell nearly 10% in trading today amid concerns about its earnings and after it sold $12 bn in common stock at $22.25, a 9% haircut to its close on Wednesday.

The news that Warren Buffett’s Berkshire Hathaway will buy $3 bn in preferred stock, which sport a rich 10% dividend, in General Electric (GE) isn’t enough to stop the downturn in the conglomerate’s shares.

Also, there is a quality of earnings danger zone in GE’s earnings. What flies under the radar screen of Wall Street analysts, as those who cover this manufacturing conglomerate tend to be industrial and not financial analysts, is the earnings engine that is GE Capital, an earnings engine that fuels GE’s profits but now seems to be running on fumes.

When it reports its next quarterly earnings on October 10, don’t be fooled by any big PR push from GE on the steadier industrial side of its business, selling train locomotives, water treatment plants, wind turbines, light bulbs and the like.

On Wall Street, GE is an entity to be feared, oderint metuant, but a look at the balance sheets at GE and GE Capital shows some startling numbers.

Use this article as a roadmap of the earnings problems submarined in GE’s footnote disclosures, which are about as transparent as a bucket of tar. GE’s numbers are weak on closer look.

GE is on the SEC’s list of companies whose stock cannot be shorted under the agency’s temporary ban. GE has also publicly stated Congress needs to pass the $700 bn rescue plan. “We believe action on a financial stabilization package must be taken–and urgently,” GE spokesman Peter O’Toole told Reuters. Read below to understand why an industrial conglomerate–which houses a sizable lender–is advocating for this bail-out.

Stock Plunge

This usually steady Dow Jones Industrials performer, which historically beats earnings estimates by a penny under former chief executive Jack Welch, has seen its shares underperform by a steep 33% below what they were trading at when Welch stepped down in September 2001.

As its market cap has fallen to $235 bn, GE’s stock has lost nearly half, 47%, of its value over the last 52 weeks as profits continue to erode at its GE Capital finance arm, a unit which has fueled GE’s earnings growth for the last two and a half decades.

GE Capital is the country’s largest non-bank financial company, a unit that deals in commercial real estate, credit cards, mortgages and airplane leasing. With $696 bn in assets–82% of its parent’s assets–GE Capital is in the league of the top ten largest financial companies in the country.

Worries About its Triple-A Rating

GE desperately needs its triple-A rating, a rating that could be in trouble and which it confers on its finance unit, GE Capital, so the finance division can borrow cheaply in the commercial paper markets.

Historically, GE’s triple-A rating enabled GE Capital to borrow via cheap commercial paper and buy its way to profit growth.

Specifically, GE Capital uses that triple-A rating to help its parent execute its acquisitions and divestitures on the cheap, moves it has often made last minute to grease the way toward meeting or beating its quarterly earnings estimates. 

It’s a just under the wire, limbo game of last minute asset sales done to placate Wall Street.

The fact that GE can’t readily get its GE Capital unit to unload and sell assets when the markets are in blackout mode poses problems when it comes to meeting Wall Street’s earnings expectations. Disappointments here have hammered its stock.

Also, the fact that GE had to sell new common stock and give Buffett such a rich premium, along with fears it may have to tap its $62 bn in credit lines, is raising concerns on Wall Street about whether GE is well-capitalized and whether its coveted triple-A rating is in jeopardy. 

Of concern, too, is the fact that GE had to shore up its balance sheet by stopping its stock buyback program, freeze its dividend for the first time in 32 years, scrap the sale of its credit card unit and curtail borrowings at GE Capital.

And despite avowals that all was fine, GE last week cut its earnings forecast  due to writedowns of as much as $500 man and credit losses. It says its profit for the year will be $1.95 to $2.10 a share, down from the expected $2.20 to $2.30 it had previously guided, and down from Wall Street’s $2.43 a share expectations.

GE also assumes its finance arm will see a 10% to 30% drop in profit, which means the unit will make up about 40% of the parents annual earnings, down from 50% last year.

Deutsche Bank Goes Negative on GE

Deutsche Bank Securities lowered its earnings per share estimates by 9% for 2008, to $2 and to $1.95 in 2009, and cut its stock price target to $26 due to “deterioration at GE Capital–driven by tighter credit markets, asset shrinkage and a debt pay-down.”

It also noted that GE Capital expects to incur $300 mn to $500 mn of mark-to-market losses on its bad assets and substantially lower real estate gains, leading Deutsche Bank to revise its estimate for a 28% decline in GE Capital’s earnings to $2.1 bn.

GE’s Debt Overhang

Start with GE’s debt, which looks huge when you compare it to its cash and its net worth, meaning, its assets minus its liabilites.

At the end of the second quarter, GE had $19 bn in cash and equivalents on its balance sheet. It also had $45.9 bn in investment securities it (hopefully) could easily liquidate.

That $64.6 bn total is against a pretty sizable $555 bn in short- and long-term borrowings. It looks worse if you use only the $19 bn, as most valuation models do. 

In this debt overhang sits $90 bn in commercial paper borrowings, short-term, cheap borrowings done in as little as one month. But those borrowings are not cheap any longer. Amidst the credit squeeze, GE’s commercial paper costs have risen.

At the same time, insuring the debt for GE Capital has soared as well, as spreads on the unit’s credit default swaps have risen to between 540 basis points to 740 bps.  

Why GE Capital Matters to GE

A huge 40% of GE’s revenue and half of its earnings comes from the notoriously opaque black box that is GE Capital, its finance unit whose disclosures are as transparent as a vat of molasses.

Thanks to its triple-A rating, GE Capital can cheaply borrow funds short-term at low rates and then lend to businesses at higher rates. The problem is, the credit squeeze has pushed higher GE Capital’s borrowing costs.

But the last several quarters have been calamitous for GE, as it couldn’t grease its numbers with instantaneous asset sales it’s so used to doing to hit its numbers, or exceed by a penny, an earnings uptrick that seems to have been going on for years.

This unit’s revenue growth underperformed in the first half, growing a somewhat tepid 7% to $37.2 bn versus the same period a year ago.

GE Capital’s Net Worth Loaded With Ephemera

GE Capital’s net worth gets weaker upon closer look. When you strip out the vapors from its net worth, you’ll see that both GE Capital and its parent are highly levered.

Teetering atop GE Capital’s teensy $60 bn in shareholders equity (or net worth) are $545 bn in short- and long-term borrowings, a sizable leverage ratio of about nine to one.

But look closely and you’ll see a stunning 53% of GE Capital’s net worth, a total of $31.6 bn, is in mushy ephemera, goodwill and other intangible assets. Meaning, it’s got $28.4 bn in hard assets.

Goodwill and intangibles are often smoke and mirrors term, both somewhat of an accounting artifice, as they are typically the price tags given by accountants and actuaries to assets picked up in acquisitions, for things like the brains in an R&D operation, the future value of licenses and patents, and such. 

Remember, more than half of GE Capital’s net worth, its book value is, well, your guess is as good as mine.

Strip out the ephemera, and on a tangible book basis, using just its hard assets, GE Capital is levered up 19 to one, meaning for every dollar of hard assets it has borrowed $19.

GE’s Net Worth is Even Shakier

Same creakiness holds true for the parent, GE. GE recorded $118.4 bn in shareholders equity, but a whopping $100.4 bn of that was in goodwill and intangible assets, a huge 85%. Meaning, GE has just $18 bn in hard assets.

Sitting precariously atop its $118.4 bn book value are $556.1 bn in borrowings, a leverage ratio of about five to one.

Strip out the ephemera and, on a tangible book basis, GE, the parent, is levered up 31 to one, meaning for every dollar of hard assets it has borrowed $31. Similar leverage ratios have caused problems for Wall Street firms like Bear Stearns, Lehman Bros. and Merrill Lynch (MER).

What Ephemera Exactly Did GE Buy?

Wandering through the impenetrable fogbank that is GE’s disclosures, often feeling like they are written in the typefont of pharmaceutical warnings, you’ll see that GE attributes its goodwill to its acquisitions of Bank BPH, Merrill Lynch Capital, CDM Resource Management, and its NBC Universal unit’s purchase of Oxygen Media, among other items.

Specifically, one of the largest goodwill balances comes from acquisitions its purchase of Merrill Lynch Capital” ($581 mn) and Bank BPH ($508 mn).

GE picked off Merrill’s middle market lending business when Merrill started its asset fire sale last December, in the midst of record writedowns and the credit crisis bearing down on the markets.

Included in this deal was Merrill Lynch Capital’s corporate, equipment, energy and healthcare finance units, but not the commercial real estate unit.

Given the unhealthy state of the financial sector, it’s right to question whether Merrill’s former unit and Bank BPH will deliver to GE’s bottom line in the near-term.

The fact that GE is doing such purchases is important because chief executive Jeffrey Immelt made a first quarter promise to slash GE’s exposure to the wobbly financial sector. 

Off-Balance Sheet Vehicles House Debt

Submarined in GE’s footnotes you’ll see a cursory disclosure about GE Capital’s off-balance sheet activities with little explanation. The sums, if added back onto the balance sheet, would make its leverage ratios look worse.

GE Capital has shoved into off-balance sheet vehicles a big $53.2 bn in securitizations, assets backed by credit-card debt, commercial and equipment financings, as well as trade receivables.

These vehicles get to sport GE’s gold-plated triple-A rating, even though these assets are backstopped by a weak $2.7 bn in credit support.

The vehicles come with triggers that force GE to pony up credit or buy them back, say, if a spike in defaults occurs. Putting them back on the balance sheet would hurt GE Capital’s debt to equity ratios–as well as the ratios for the parent.

Load in the off-balance sheet items, and on a tangible book value basis, GE Capital is levered up 21 to one.

GE Capital’s Toxic Assets

Moreover, GE Capital has $15.9 bn in illiquid assets, the toxic level 3 assets, that the company can’t get a pricetag on because there is no market to mark them to. So they sit dormant waiting to be unloaded.

It’s got another $38.8 bn in level 2 assets, which may be more easily sold than its level 3 assets, though the credit markets for them still largely remain in blackout mode.

These sums in total easily swamp the $18 bn tangible book value of GE.

Does GE Deserve a Triple-A Rating?

But seemingly without plumbing the depths of these mysteries, Standard & Poor’s has given GE a triple-A rating, an honor not given most other financial concerns and one conferred on GE Capital because its industrial parent backs its debts, (it also has a triple-A rating from Moody’s Investors Service).

Only nine or so other companies enjoy a triple-A rating, last I checked (excluding supposedly government-backed companies such as Fannie Mae).

The list is: Berkshire Hathaway, ExxonMobil, Pfizer, American International Group, Bristol-Myers Squibb, Johnson & Johnson, Merck and United Parcel Services, and General Electric.

GE Elbowed Out?

GE is undergoing a massive restructuring which involves asset divestitures, but it could be elbowed out in a bum’s rush to a very crowded exit door in its asset sales by Citigroup (C), JPMorgan Chase (JPM), and Bank of America (BAC) and just about any other financial services firm caught in the downdraft.

Oh and by the way–the IRS is now auditing GE’s tax returns for 2003 to 2005.

 

24 Responses to “What Buffett May Be Missing at GE”

  1. Comment by Don

    October 1st, 2008 at 3:22 pm

    Buffett is getting very sloppy with his purchases. I’ve seen him buy things I would not even consider. He thinks his past returns and endorsement will take the stock price to new highs (he only shows up after he makes huge investments).

    Why doesn’t the FBI investigate Moody’s and S&P? They deserve blame for our problems because their ratings are not worth the paper they are written on. How many times have they downgraded a stock or investments AFTER official announcements of how BAD the company was? Yet, they continue to get a free pass from the media and the government.

  2. Comment by Timw

    October 1st, 2008 at 4:16 pm

    Nothing new here in Buffett’s model.

  3. Comment by SR

    October 1st, 2008 at 5:14 pm

    Don,
    Buffett doesn’t care about GE’s stock price going to a new high becuase he is invested in non-convertible preferred shares which yield 10%. As long as GE doesn’t go bankrupt, he should be good. Its so nice that you won’t consider such investments because there is no way GE is going to issue the same deal to you. (or may be they will consider since you sound way smarter than Buffett..lol)

  4. Comment by Alberto

    October 1st, 2008 at 6:57 pm

    Be Carefull with GE it owns a network CNBC that states everyday that GE if fine. They hammer other companies on rumors and factless news on the airwaves to cause panic. Just the other day they had the president of GE that they were well capitalized with plenty of monies in reserve. Why do they need to raise capital?

  5. Comment by Bob Meyer

    October 1st, 2008 at 9:29 pm

    GE has not been a manufacturing corporation for many years. Under the mis-management of the most overrated CEO in recent history ,Jack Welch, GE abandoned research, became an importer of goods and invested in financial services because it was the only thing that glorified accountant understood. The technical excellence and reliable products that once was GE has been replaced by tax lawyer gimmicks and creative accounting. (”How much is goodwill worth?” “Let’s put down ten billion or so.”)

    Buffet is buying in because he is confident that his political support for Obama will result in billions of dollars to “rescue” the financial services industries. GE is also confident that Obama will bail them out, as can be seen by the unconditional love shown by NBC, CNBC and MSNBC for “the One”.

    When I was young GE’s motto was “Progress is Our Most Important Product”. Today their motto is “Political Pull is All We Have Left”.

  6. Comment by monkeyfurball

    October 1st, 2008 at 11:52 pm

    Boy, when shorting is back in style, watch out GE. It’s just another AIG only lots more toxic. Buffet only put $3 Billion in it. That’s pocket change for him, but this stock is a very dangerous buy. I think he’s let Hollywood get to him. Being on cnbc all the time makes him feel like one of the talking heads there. So, buying into the network is maybe some sort of psychological chummy way of getting close to the boneheads at cnbc that worship the ground he strolls on.

  7. Comment by Rob

    October 2nd, 2008 at 3:23 am

    I read a bit of news about GE. Funny how the most negative often seems to be from FOX. Not that GE Capital isn’t affected by the credit situation (although in a far different way than financials like BAC). Just that, even in the tone of the article, hard not to think as much about FOX’s credibility as it is about what the article reports.

  8. Comment by JAMES SEGAR

    October 2nd, 2008 at 3:42 am

    your network is soooo biased toward anything GE says or does dut to the fact that they own NBC and competes with FOX for business and viewers…..BUFFETT has averaged almost a 20% gain in his portfolio since 1950………now how in the world can you idiots at fox criticize that!!!!!

  9. Comment by Greg

    October 2nd, 2008 at 5:31 am

    It is not what Mr. Buffet says that matters…it is what he does. Mr. Buffet has seen the toxic waste and tried to buy some of it at his valuation and he has no takers so he is going to the other side of the trade…buy best of breed companies that own the toxic waste and have thier backs against a wall because the government is going to put a higher valuation on the assets than he would…he gets his valuation and taxpayers get taken to the cleaners by him. Of course Mr. Buffet wants the bailout to pass…he has a huge bet on and wants the government (taxpayers) to cover it. Mr. Buffet’s assertion that he would take 1% of the take for the government is like a Casino taking 1% of a sports bet…either way you win. He IS NOT asserting that he would buy the assets because he has looked at them and is unwilling to pay the sellers price…but the US Government has to pay the price…In the end taxpayers lose and Mr. Buffet wins…of course, the government could just buy $700 billion of Berkshire Hathaway stock….Don’t listen to Mr. Buffet’s words…watch what he does.

  10. Comment by Pak Tam

    October 2nd, 2008 at 7:59 am

    I am seaching for some idea to write in my blog… somehow come to your blog. best of luck. Pak Tam

  11. Comment by GKA

    October 2nd, 2008 at 10:14 am

    Complete misunderstanding of why Buffet is the richest man in the world. Be zen; take a deep-breath and repeat this mantra: short-term pain, long-term gain, short-term pain, long-term gain…

  12. Comment by Randy

    October 2nd, 2008 at 10:33 am

    Think BIG PICTURE. Buffet is backing a Socialist movement. His ownership in these companies secures his future control of them. It’s his payback for his financial support of the Dems.

  13. Comment by Dave

    October 2nd, 2008 at 11:15 am

    Sounds like a “bad management burrito”. Run.

  14. Comment by A.A.

    October 2nd, 2008 at 12:41 pm

    Warren Buffett gave an interview on Charlie Rose to promote his GE purchase. Warren is everybody’s “favorite grandfather who is a billionaire but who wont’ give his grandkids a nickel”. Buffett didn’t give American investors a nickel last night during his Charlie Rose interview either. All he did was promote the “sweet deal” that GE gave him in preferred stock which has led to this serious fall and dilution of GE common stock.

  15. Comment by Stephen Maupin

    October 2nd, 2008 at 1:57 pm

    Berkshire Hathaway easily converted their common shares to preferred shares. The money came out of the stock market, the price of GE feel and the money went back to GE as a sweetheart stockpurchase. None of us would be allowed to do that. This is not considered inside trading as he is not an officer or Board Member…..but someone from his group is. The small stockholder of GE should be wary. Dividends will be a long time coming in this mess. All the fluff is about to exit GE Financial and goodwill will be worth zero…..

  16. Comment by T. M. Hardy

    October 2nd, 2008 at 3:32 pm

    What the author of the attached article did not mention is that even the company’s industrial businesses are in jeopardy of a drastic, and perhaps dramatic, slow down because of the ever slowing global economic slowdown caused by the present crisis and other macroeconomic factors.

    The financial services companies the Wall Street, and many other financial pundits, had long espoused GE spin off are threatening the tenability of the company’s coveted triple A rating.

    It is very foreseeable that a new CEO of the company will be chosen in the near future and that many of these financial services businesses will be sold off at the first discernible signs of a true recovery in the financial markets, especially by a new CEO.

    Conversely, the company might be forced to enter the commercial banking business to support its lending activities and better match its funding/ lending maturities, this would inevitably remove the company from the status of triple A and to more likely double A to match peers or comparable size and given its off balance sheet debt.

  17. Comment by Chet F

    October 2nd, 2008 at 3:36 pm

    Congress is just like my kids were when they were young, What part of no don’t they understand? Each time they do something it just makes things worse!!! The sun will certainly rise tommorrow. Unless congress gets involved.

  18. Comment by T. M. Hardy

    October 2nd, 2008 at 3:53 pm

    What the author of the attached article did not mention is that even the company’s industrial businesses are in jeopardy of a drastic, and perhaps dramatic, slow down because of the ever slowing global economic slowdown caused by the present crisis and other macroeconomic factors.

    The financial services companies that Wall Street, and many other financial pundits, had long espoused GE spin off are threatening the tenability of the company’s coveted triple A rating. The company’s recent preferred stock investment by Mr. Buffett was an attempt to shore up the company’s balance sheet for the preservation of its AAA rating, and not the advertised reasons it told the market. Additionally, any new “opportunities” that the company would take advantage of would certainly be industrial in nature and not financial services oriented, as this would exacerbate the company’s already troubling structure.

    It is very foreseeable that a new CEO of the company will be chosen in the near future and that many of these financial services businesses will be sold off at the first discernible signs of a true recovery in the financial markets, especially by a new CEO.

    Conversely, the company might be forced to enter the commercial banking business to support its lending activities and better match its funding/ lending maturities, this would inevitably remove the company from the status of triple A and to more likely double A to match peers or comparable size and given its off balance sheet debt.

    Toia

  19. Comment by T. M. Hardy

    October 2nd, 2008 at 3:53 pm

    What the author of the attached article did not mention is that even the company’s industrial businesses are in jeopardy of a drastic, and perhaps dramatic, slow down because of the ever slowing global economic slowdown caused by the present crisis and other macroeconomic factors.

    The financial services companies that Wall Street, and many other financial pundits, had long espoused GE spin off are threatening the tenability of the company’s coveted triple A rating. The company’s recent preferred stock investment by Mr. Buffett was an attempt to shore up the company’s balance sheet for the preservation of its AAA rating, and not the advertised reasons it told the market. Additionally, any new “opportunities” that the company would take advantage of would certainly be industrial in nature and not financial services oriented, as this would exacerbate the company’s already troubling structure.

    It is very foreseeable that a new CEO of the company will be chosen in the near future and that many of these financial services businesses will be sold off at the first discernible signs of a true recovery in the financial markets, especially by a new CEO.

    Conversely, the company might be forced to enter the commercial banking business to support its lending activities and better match its funding/ lending maturities, this would inevitably remove the company from the status of triple A and to more likely double A to match peers or comparable size banks and given its off balance sheet debt.

    Toia

  20. Comment by Pat H.

    October 2nd, 2008 at 9:13 pm

    I sold my GE Stock recently because of MSNBC.

  21. Comment by Marty Ueland

    October 3rd, 2008 at 1:17 am

    I have admired Warren Buffet for all of these years as the wise guy, but now I am 65 years old, and find he is not. Buying into such a one sided liberal group of people takes all of the respect away.

  22. Comment by john

    October 3rd, 2008 at 10:32 am

    GE either needs to go way down and possibly fold, or fire their CEO who has taken them down the tank in the first place.
    Save the company or the CEO. I would think that would be obvious to the Board.

  23. Comment by Douglass Montrose-Graem

    October 3rd, 2008 at 10:57 am

    GE totters under three handicaps simultaneously:

    1. A “trading with the enemy Iran” CEO who angered disabled veterans like me for doing clandestine dirty business with Iran which does the clandestine dirty business of killing our American heros in Iraq. [ I have asked millions of my fellow veterans to boycott GE merchandize]

    2. NBC subsidiary - sunk to the level of being a cheap apparatchnik for Obama - alienating a good half of Americans.

    3. The CEO - clung to by a “corrupt spineless board of directors of cronies”

    Once Buffett has picked the bones clean, what is left to owners of GE common stock?

  24. Comment by Matt

    October 6th, 2008 at 6:09 pm

    Right On,

    I did the same exercise the other day at the SEC edgar web site,
    Since I have not been in the market, I have had no reason to evaluate GE’s
    financial statements until this weekend.
    I felt like Rip Van Winkle waking up to a balance sheet from Hell.
    This is worse ratings than they gave to mortgage backed securities.

    I feel GE will go down unless directly funded by the Fed, with the commercial paper market falling 100 billion a week, and GE’s hundreds of billions in short term funding, GE’s new 12 or 15 billion in new capital should last about 1 week.

    The good news is that 28 percent of the commercial paper market matures in the next 7 days, and that the US borrowers actually were able to roll about 300 billion last week. The bad news is that the only money in the
    US will be either from banks or directly from the Fed, which will be deciding which US companies do not go into receivership when they cannot borrow money in the market.

    http://www.federalreserve.gov/releases/cp/outstandings.htm

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