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What to Watch For In GE’s Earnings

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July 10, 2008 – Comments (1) | RELATED TICKERS: GE

What to Watch For In GE’s EarningsBy Elizabeth MacDonald

There’s plenty to be worried about when General Electric (GE: 27.47, +0.28, +1.02%) reports its second quarter earnings before the opening bell tomorrow.

This usually steady performer, which historically beat earnings estimates by a penny under former chief executive Jack Welch, in the first quarter tossed a hand grenade down the volcano that is now the stock market when it announced earnings from continuing operations of $4.4 bn or $0.44 per share, down a hefty 8% from the first quarter of  2007.

At $27, GE’s shares have underperformed by a steep 20% below what they were trading at when Welch stepped down in September 2001.

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 seems to be running at times on fumes.

GE pegged its first-quarter earnings belly flop, painfully short of analysts’ estimates, on the credit crisis, namely, due to the markets turning suicidal last March after the Bear Stearns collapse.

Weeks before Bear imploded, Immelt had given a robust outlook. The markets in short order punished GE, and the company lost $45.7 bn in market value in just one day. The second quarter earnings consensus estimate says GE will earn 54 cents a share, up a penny from the same period in 2007.  

Don’t be fooled by any big push by GE to toss the klieg lights on the steadier industrial side of its business, selling train locomotives, water treatment plants, wind turbines, light bulbs and the like. Look beyond the news that GE now plans to spin off its entire consumer and industrial group. The overarching theme here is that GE’s balance sheet looks pretty creaky.

A huge 40% of GE’s revenue comes from the notoriously opaque black box that is GE Capital, its finance unit whose disclosures are as transparent as a vat of molasses. And this unit’s revenue was flat in the first quarter, growing a teensy 3% to $18.1 bn versus the same period a year ago.

More specifically, GE Capital’s deal making has a significant impact on GE’s results.

The financial behemoth that is GE Capital, with $683.8 bn in assets, puts it in the league of the top ten largest financial companies in the country, behind Wachovia.

Behind GE’s confession in the first quarter, where it said it got buffaloed by the credit crisis, is the fact that it can’t readily get its GE Capital unit to unload and sell assets when the markets are in blackout mode.

Meaning, GE 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 feels like has been going on for a generation.

Although, when it comes to Wall Street analysts, GE is an entity to be feared, oderint metuant, a look at both GE and GE Capital’s balance sheets shows some startling numbers.

First off, GE Capital has shoved into off-balance sheet vehicles a huge $54 bn in securitizations, assets backed by credit-card debt, commercial and residential financings, and equipment financings.

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 wreck GE’s already shaky debt to capital ratios even more.

GE Capital’s net worth, its total shareholders equity is $57.7 bn.

But check this out, look closely and you’ll see a stunning 54% of GE Capital’s net worth, a total $31.5 bn, is in mushy goodwill and other intangible 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 ephemera like the brains in an R&D operation, the future value of licenses and patents, and such. GE Capital has been in acquisition and divestiture mode for some time.

Moreover, GE Capital is levered to the ceiling. Teetering atop that teensy $57.7 bn in shareholders equity (or net worth) is $536.6 bn in short and long term borrowings, a sizable leverage ratio of about nine to one. That doesn’t include the $54 bn in securitizations warehoused in off-balance sheet vehicles.

Remember, more than half that book value is, well, your guess is as good as mine. Breaking the debt down, GE Capital has got $198.7 bn in short term borrowings and $337.9 bn in long term borrowings.

Moreover, GE Capital has about $14 bn in illiquid assets, the toxic Level 3 assets, that it can’t get a pricetag on because there is no market to mark them to. So they sit dormant waiting to be unloaded.

Same holds true for the parent, GE. GE recorded $115.7 bn in shareholders equity, but a whopping $99 bn of that was in goodwill and intangible assets, a huge 85.6%. Sitting precariously atop that book value are a breathtaking $547.8 bn in borrowings, a leverage ratio of five to one.

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

GE desperately needs that triple-A rating so GE Capital can borrow cheaply in the commercial paper markets. GE Capital mints GE its money to do its acquisitions and divestitures to boost its earnings.

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,

But back to that goodwill. Where did that goodwill come from?

Wandering through the impenetrable fogbank that is its disclosures, often feeling like they are written in the typefont of pharmaceutical warnings, GE Capital buries in a footnote this gem.

The “largest goodwill balance increases from acquisitions arose from the purchase of Merrill Lynch Capital” ($520 mn at GE Commercial Finance), among other items.

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.

Check to see whether Merrill’s former unit delivers to GE’s bottom line in the upcoming and future quarterly results.

The fact that GE is doing such purchases is important because chief executive Jeffrey Immelt made a first quarter promise to get GE to slash its exposure to the financial sector. With its murky, touchy balance sheet, GE’s acquisitions in this environment need to be scrutinized.

And its asset sales too, so important for hitting its numbers, as GE could be elbowed out in a bum’s rush to a very crowded exit door by Citigroup (C, Merrill Lynch (MER: 29.00, -0.74, -2.48%), JPMorgan Chase (JPM: 34.56, +0.28, +0.81%), Freddie Mac (FRE: 8.09, -2.17, -21.15%) and Bank of America (BAC: 22.26, +0.20, +0.90%), and just about any other financial services firm caught in the downdraft.

Like I said at the outset, investors in GE can’t be happy, as shares are 20% or so below the price they were trading at when GE’s former head Jack Welch stepped down–he being the executive who raised to an art form this under the wire, limbo game of last minute asset sales to placate Wall Street.

1 Comments – Post Your Own

#1) On July 10, 2008 at 2:20 PM, blade5adj (< 20) wrote:

The "off-balance sheet" debt you talk about is remarkably reminiscent of Enron, who essentailly sold assets back to themselves and monetized contracts to make earnings targets. They also moved debt off-balance sheet to make their situation look a lot rosier. But even during their heyday, Enron didn't even have close to a triple A rating.  They were only three steps above junk bond status, and that was what eventually doomed them (among other things haha).

I don't feel like GE is in the same danger as Enron, and I do feel like their triple A credit rating is warranted.

Goodwill stays on balance sheets after you've purchased any asset.  Since GE is a conglomerate, and grows through acquistion, it would make sense that a significant amount of their balance sheet assets would be goodwill.  That's basically just the excess in purchase price of the asset to what that company's book value is, and since accounting terms record the cost of assets and not what they're actually worth (you won't find the value of the brand name: "Coca-Cola" anywhere on their balance sheet), there's going to be a significant amount of goodwill recorded when GE snaps up these companies.  Think of the goodwill that would be incurred by purchasing NBC Universal: what hard assets would that company have?  It's mostly intellectual assets (intangible), and that's got to be recorded on the balance sheet somewhere.  That doesn't mean that the goodwill is out of whack.

As far as your concern over leverage, I would be way more concerned if they didn't have any leverage.  Leverage is what allows companies to grow, and when properly employed, can provide significant increases to revenues and rates of returns. 

I'm guessing they have a AAA rating because no one is concerned with them having to pay off their debt, thanks to steady cash flow from their other businesses. The only concern with their illiquid assets is if they suddenly had to unwind them, and cash them in.  I'm guessing they're not going to have to do this, and if they sell off their appliance division, this cash can further be used to pay back debt, or invest further in other divisions like wind turbines.  

This is a rough time for everyone, but I'm guessing GE Capital is going to be able to outlast the current upsets in the market by clinging to the other businesses.  I think everyone knows right now that unwinding assets in this division is going to result in significant losses, and should only be done if necessary.  The fact that they have enough cash to have a GE Capital division speaks volume of their abilities to pay off debt.  They can issue their own.

I'm long GE, because I feel like their investments in renewable energy are really going to pay off down the road.  Granted they've gone through some troubles recently, but frankly, who hasn't.  

Props to you though if you're right.  We'll all see soon enough :) 

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