General Electric (GE) Earnings Review
On Friday, GE reported their FY 2008 3rd Quarter Earnings. Links for the press release, conference call transcript and presentation. GE’s diverse business model makes their earnings report a useful bellwether for the overall economy. Finance, traditional and alternative energy, media, transportation, aviation, military, medical equipment, water treatment – GE does a bit of everything and their earnings report should be a very good indication of what’s working and what’s not.
On 25 September, GE released lower earnings guidance. They followed that on 1 October with an announced capital raise issuing $3 billion of preferred stock and warrants for $3 billion of common stock exercisable at $22.25 to Berkshire Hathaway along with a $12 billion public common stock offering priced at $22.25. The preferred stock issued to Berkshire Hathaway pays 10% and is redeemable after three years at a 10% premium.
As a shareholder, I was hoping GE would shed some light on why they felt they needed to raise capital. They did explain the reasons behind it, but not why they did it in a placement with BRK rather than a rights offering or other approach. SVP, Vice Chairman and CFO Keith Sherin stated, “We had a liquidity plan that said we were going to get our bank lines plus our cash equal to our CP [commercial paper] by the end of the year. After our earnings call last week -- or the preannouncement, we said that may not be fast enough and we went right to work on -- well, how do you accelerate that? That's why we did the equity offering. We have accelerated today our bank lines plus our committed cash are greater than our CP.” Essentially, GE bought an insurance policy against a credit market lock-up. A prudent move even if it was an expensive insurance policy.
Given all the talk about credit markets tightening, I thought this statement by Mr. Sherin was very interesting, “…the debt markets have been volatile, but we are still funding ourselves without any issues. If you look at CP, in fourth quarter '07 the average cost of our commercial paper program where we had higher balances was about 5%. In the third quarter of '08 the average cost was 2.5%; and that is the same average cost for the last couple of weeks.” According to this statement, GE is not only able to borrow in the commercial paper market, they’re doing it at a lower cost than a year ago. Make your own conclusions about the severity of the credit crisis we keep hearing so much about.
GE has reduced outstanding CP to $88 billion and plans to reduce it below $80 billion by the end of the year. With the recent capital raise, cash plus bank lines exceed outstanding commercial paper. They’re also investigating the recent Federal Reserve announcement of a commercial paper facility as an additional back-up funding source.
The knock on GE has been fears about the financial side of the business. During the 25 Sep guidance release, GE indicated they expected to earn about $2 billion from financial services and GE met that lowered target.
The presentation provides some additional color on the assets behind GE Capital Finance. There are $413 billion of commercial assets and $209 billion of consumer assets with broad diversification across type of asset and geography. 59% of commercial and 79% of consumer assets are outside the US. There are no SIVs, CDOs or CDS exposure on the books. Delinquencies and non-earning assets are up and do not appear to be leveling off. However, GE has been increasing loss provisions faster than write-offs for four consecutive quarters. There were $451 million of loan losses this quarter and $762 million was added to loss reserves. From the transcript, it sounded like total loss provisions are expected to be $6.6 billion by the end of the year, but the statement wasn’t clear.
GE includes a chart of historical loan losses in the earnings call presentation. The estimated loss for 2008 is 1.2%. The highest loss rate shown was during the 1990 – 91 recession at 2.0%. GE believes they have a higher quality, more diversified loan portfolio than they did in ’90-’91 and that they won’t see that level of losses this time. It would have been interesting to see the chart run back to the late 1970’s. GE lists a globally oriented portfolio, smaller average loan size, and a 70% average loan to value on real estate as some of the advantages today’s portfolio has over ’90-’91.
Outside of the finance business, things look pretty good. Energy infrastructure (energy, oil/gas) had a 32% increase in revenue and 31% increase in profit compared to the year ago quarter. Technology infrastructure (aviation, healthcare, transportation) had revenues up 9%, profit up 2%. NBC Universal revenues were up 35%, profits up 10% largely on strong results from Olympics coverage.
The advantage of GE’s diversified business model is that something will always be working. The disadvantage is that something will always be struggling. Even with the weakness in the financial business, it still accounted for nearly 45% of GE profits this quarter. The quarterly earnings of 45 cents per share don’t leave a lot of cushion to cover the 31 cent quarterly dividend. Management was confident the dividend was safe, but we’ve heard that from other companies before.
The $3 billion of preferred stock sold to BRK represents a $300 million or 3 cent per share annual expense GE didn’t have before. Since the new capital is intended to raise cash for defense against a tight commercial paper market, there won’t be any new income associated with that money. Similarly, $12 billion of new shares will also be entitled to dividend payments that will total $670 million per year at the current rate.
Mr. Buffet’s warrants and the new offering put a smart money price of $22.25 on GE shares. Investors interested in adding GE should look for a significant discount to that price to make buys.
TARP and the new Fed commercial paper facility may offer some advantages to GE going forward, but there’s no way to quantify that possibility.
I believe shareholders would have been better off with a dividend cut to preserve capital over the preferred issue to BRK. Cutting the dividend from .31 to .23 per quarter would have saved more than the $3 billion over the course of one year. A one-quarter dividend suspension would also have saved more than $3 billion. In either case, shareholders would have taken a short term hit to income, but wouldn’t be saddled with the annual bleed from the preferred.
The company is taking prudent steps to maintain a high credit rating and protect against tight credit markets. But further weakness in their loan portfolios or a fall off in the industrial businesses would make it very difficult to maintain the dividend.
As a shareholder, I feel like it’s too late to sell and too early to buy more. If the price jumps much above the $22.25 smart money target, I’ll probably lighten up and look to buy back at a lower price. A drop below $18 would be low enough to look attractive even with a possible dividend cut. Those buying GE today will probably be happy five years from now. Those who wait for a better price or average in will be even happier.
Anyone buying because Warren Buffet bought needs to recognize they aren’t getting the same deal Warren was able to negotiate. If Berkshire has any regrets and would like to sell a slice of that preferred with warrants at cost, let me know.
For those interested in something like GE without the financial operation, fellow Fool DemonDoug is recommending Siemens (SI). ABB would be worth a look as well.
Questions I wish analysts had asked:
Why did you do the placement with BRK over other capital raising alternatives?
What other options did you consider?
How much is currently set aside for loan loss reserves?
You list a 70% average loan to value for your real estate loan portfolio. Is that based on values at origination or current values?
I’ll shoot an e-mail to investor relations and share the answer when I get it.