Back on September 1, 2007, GE stock hit $41.40 per share. It is currently trading around $21.30 or nearly 50% from its peak.
Ultimately, CEO Jeffrey Immelt must bare the ultimate responsibility for this lackluster performance. Fairly or unfairly, GE Capital expanded aggressively and collapsed under his watch and he is responsible for guiding the proverbial ship through the storm. So it is with that in mind that I seek to analyze what I perceive to be GE’s current strategy and recommend a new one to improve shareholder value.
What Businesses are in GE?
Looking at GE we see a massive, diversified, and profitable conglomerate with a lot of very good but very unrelated businesses. NBC, airplane engines, and commercial financing carry only so many opportunities for cost reduction and economies of scale.
Their businesses also include medical devices, power generation, and household appliances. Within the power generation segment they sell gas turbines, generators, Integrated Gasification Combined Cycle technology (IGCC systems convert coal and other hydrocarbons into synthetic gas), steam turbines, nuclear reactors, nuclear fuel and support services, and motors and control systems for oil and gas extraction and mining. In just that segment of the business they have an astonishing range of products. Any one of these products would serve as a large and viable business in and of itself, but GE has them all rolled up under its corporate umbrella.
Analyzing GE’s Business is a Frickin’ Nightmare
And therein lies the problem: Analyzing GE’s business and where its going is an absolute nightmare. I could expound on any one of those products ad nauseum, but GE’s current composition requires a simply massive amount of analysis to assess and understand the risks involved with ownership (I might add this is a criticism that can be levied on many companies in this day and age). That ripples out amongst investors whether they’re institutional or individual.
Since the financial collapse, investors are far more risk averse and naturally so. Hence the rush into gold during the past two plus years. So looking at GE with all of its subsidiaries and a balance sheet that includes a very large financial component ($322 billion in receivables for GE Capital alone), its easy to see why investors have said “why bother” over the past decade. Add this to the fact that the company is exhibiting tepid revenue growth and the list of concerns to an investor is daunting.
One would tend to think that General Electric’s diversification across both product lines and geography would have done a better job protecting it from the maelstrom of 2008. The problem with major financial crises is that correlations between assets tend to increase meaning that businesses with different exposures to the ebbs and flows of the business cycle suddenly all react negatively to it.
The implications of this for GE are that its decades long efforts to become a diversified company have been for naught because the primary argument for that diversification, safety during crises, has been proven to be nullified by severe liquidity events in the financial markets. What makes the conglomerate structure even more contradictory to the idea of diversification is that diversified assets are supposed to be independent of one another, but in a conglomerate like GE the combination ultimately serves to support each division; in effect all of the businesses become correlated even if they would not be if separate.
Another aspect of GE’s recent governing strategy that I find worrisome is their recent emphasis on using government contracts and bailouts to bolster their business. By way of a loophole in the regulations underpinning the Federal Deposit Insurance Corporation, GE was able to rescue its borderline insolvent GE Capital division by using the Temporary Liquidity Guarantee Program and issue nearly $74 billion in debt. Without that guarantee it is unlikely GE Capital would have been able to continue to function given its current business model which, like so many financial institutions that stood on the precipice, was dependent on borrowing short and lending long. Once the short-term markets tightened up, firms whose operations depended on such cheap financing faced severe liquidity issues. What this tells us is that GE Capital encumbers General Electric with so much financial risk that bankruptcy is a real danger to not just the subsidiary itself, but the entire firm during turbulent times. This has to be factored in to any analysis we do of General Electric.
Recently, the Wall Street Journal published an op-ed entitled “The Great Misallocators“. The crux of the piece was that politically allocated capital is inherently less efficient than is privately allocated capital and as a result will lead to slower economic growth than the alternative. The Wall Street Journal epitomized the relationship between GE and the United States government with the following quote from Jeffrey Immelt: “The interaction between government and business will change forever. In a reset economy, the government will be a regulator; and also an industry policy champion, a financier, and a key partner.”
Now obviously the government needs to make purchases from private companies to operate and for many of those purchases GE is an ideal supplier. But GE has been going to the Obama Administration hat in hand and pushing the administration’s policies such as cap and trade and the expansion of wind generation so as to curry favor amongst federal appropriators. Given the historic inefficiency of state-owned enterprises as observed across multiple countries, I find such a cozy relationship very uncomfortable as an investor. There is an inherent conflict of interest when the government serves as both partner, financier, and regulator (see housing market). How such a relationship could rebound on GE is impossible to foresee and therefore, impossible to price. The government doesn’t give federal contracts solely based on merit (much to the chagrin of most of the electorate).
For GE to want to ingratiate itself to such a murky market serves as an unwanted distraction from appealing to the consumer driven market it should be working to win over. Or worse, its a tacit admission that it can’t win over that market anymore. Perhaps my paranoia at the conflicted relationship that may ensue between the U.S. government and GE is just that since currently, government contracts make up only a paltry 4% of revenues (though how you factor in the nearly $80 billion in government financing may push that number substantially higher). But I suspect Mr.Immelt has every intention of expanding GE’s dealing with the government greatly and as with all investing our concern is with the future as much as it is with the here and now.
Using what I consider to be some very optimistic earnings estimates based on what analysts currently believe to be GE’s forward earnings and assumptions including a return to somewhat normal volatility levels, I arrive at a valuation of $24 per share for General Electric or around a 13% premium to its current price. That is hardly the type of appreciation potential that would make me jump at investing in this company (and again I must warn the reader that this is based on very liberal assumptions). Now the company does seem to be making some strides in managing its balance sheet more prudently since the days when GE Capital drove the firm. In 2008, making adjustments for goodwill and cash and equivalents, GE had a long-term debt to equity ratio of over 20x whereas that has now dropped to around 8x. So the firm has reduced the financial risk it encumbers shareholders with, but even that level of leverage is still far too high and as I have mentioned in previous pieces, results in a higher discount rate being applied to the valuation of the equity of the company.
What Should GE Do?
So what is GE to do? How can it regain its previous shareholder shine? I see a multitude of paths forward for this company. My personal preference is to divide the company into stand-alone businesses and distribute equity in the new firms to existing shareholders. There is tremendous unrealized shareholder value in this company, but most of it is being held down by the risk premium associated with the difficulty of analyzing the company and the fact that GE Capital is now considered a much more risky venture than it previously was. Complexity and leverage begets risk to shareholders and risk leads to discounted shares.
A very basic plan would be to divide the company into GE Capital, Energy Infrastructure, Technology Infrastructure, NBC Universal, and Consumer and Industrial and let them thrive on their own. The argument could be made to divide those divisions even further for instance airplane engines could easily be its own division. As could medical devices or home appliances. Using similar assumptions to the previous scenario and valuing the components separately I arrive at a combined value of just over $28 per share or about a 32% premium to today’s value. What the valuation shows is that GE Capital is the dog of the group. It is also dragging down the value of the entire firm because of the intrinsic risk associated with it and because implicitly, the other divisions of the firm could see their resources shunted to bolster GE Capital during another financial melee.
An alternative might be to redouble efforts to deleverage the company. Since GE Capital is the source of most of that debt it would make sense to shrink its balance sheet and finance only high quality borrowers. GE didn’t start out as a finance company and it almost collapsed trying to be one – now seems like a good time to end that practice. GE’s future isn’t in lending. Its in medical services, energy infrastructure, and technological infrastructure. With the collapse of the credit induced housing bubble firms are slowly getting back to investing capital in improving things that make people’s day-to-day better. This is not to say GE Capital has no place in the firm, but its place should be similar to that of other finance arms in large industrial conglomerates: as a source of financing for the customers of its divisions that produce goods and services not as a lending arm in and of itself.
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