GE: A Hedge Fund In Disguise

Dec.31.12 | About: General Electric (GE)

Overview

General Electric (NYSE:GE), started by legends Thomas Edison and J.P. Morgan in 1892, is the oldest current member of the Dow Jones Industrial Average. It began as an industrial powerhouse focused on profiting from the booming electricity industry of the early 20th century. General Electric was also a pioneer in many appliances and tools that benefited from electricity such as refrigerators, lighting and radios. As time passed, however, GE morphed into something else. While still an industrial powerhouse in some respects, GE better resembles a bank today than the industrial giant it was 100 years ago.

A thorough look through GE's most recent 10-Q produces some very interesting numbers for GE shareholders. The composition of the balance sheet, cash flow results and income statement results paint a very different picture than you might imagine if you still believe GE is first and foremost an industrial company. I will argue that General Electric Capital Corporation (GECC) has grown so large that investors should consider GE a bank primarily and an industrial conglomerate second.

Balance Sheet

GE's balance sheet is massive at $699B of total assets as of 9/30/12. However, only $223B of that amount is assets that GE uses to conduct its manufacturing and services businesses. The rest of it (80.4%) is in assets used by GECC to finance various investments and loans. In addition, GECC controls 90.9% of the cash and cash equivalents of the consolidated company. On the liabilities side, GECC accounts for: 94.3% of short-term borrowings, 98.2% of long-term borrowings and 84.0% of total liabilities. GECC also boasts 66.4% of the consolidated company's shareholder equity. Does this sound like a manufacturing firm to you?

The staggering domination of GECC can be more readily seen graphically. Note: all graphs were created by me specifically for this article.

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Income Statement

GECC's power isn't as freely noticed on the income statement, but I would like to point out a few glaring statistics. GECC makes up 31.7% of total revenue and 29.5% of costs but accounts for a much larger piece of earnings. GECC contributes 49.5% to EBIT, 54.0% to operating earnings and nearly half (48.9%) of GE's consolidated net income. If I thought I was a shareholder of a manufacturing and services company, this would scare me. As we all know, financial firms, particularly enormous ones, are especially susceptible to financial shocks. This was evident during the last financial crises when General Electric common stock dropped all the way to six dollars before rebounding to over 20 at present. When you consider that fully, half of their earnings (and possibly more) could be wiped out during the next financial shock, extreme caution is warranted for long-term shareholders.

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Cash Flows

The statement of cash flows provides perhaps the most convincing proof GE shareholders need that they are held captive to the booms and busts of financial markets and products. A close look at the change in cash flows for the first nine months of 2012 reveals some startling numbers. First, GE Capital is responsible for 74% of the consolidated company's operating cash flow. Given the manufacturing company's dominant and ubiquitous products, one might think the cash flow statement is a place this strength would show itself. However, what we see is GECC once again dominating the little brother manufacturing wing. Turning our attention to Cash from Investing and Cash from Financing activities, it seems as though little brother doesn't even exist. GECC is responsible for not only the entirety of the change in cash from investing activities, but also the deficit that GE's manufacturing operations produced. The story is similar in cash from financing activities as GECC provides 95.4% of the increase there as well. Turning to total change in cash, GE's manufacturing wing barely shows up at all, showing a small deficit, as GECC produces every penny of positive cash flow. The magnitude of GECC's domination of the consolidated General Electric Corp. can be readily noticed in the graph below.

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Further Examination of GECC's Holdings

Now that we have established that General Electric Capital Corp. is the dominant entity in its partnership with General Electric Corporation, let's take a closer look at what GECC actually holds. First, it should be noted that little brother GE holds almost nothing in the way of investment securities ($27M). By contrast, GECC holds a whopping $48.7B. What's even more striking to me is that every penny of these massive holdings is classified as available for sale. This means that GECC has no intention of letting these securities mature. By way of inference, we can concur that GECC must be trading in and out of at least some of these securities or they would be classified as held to maturity. This is striking to me as it sounds more like a hedge fund than an original member of the Dow Jones Industrial Average. Half of GECC's $48B in available for sale securities is in U.S. corporate debt and the other half is made up of smaller amounts of asset-backed securities, municipal bonds, mortgage-backed securities, non-U.S. government debt and others. It is easy to understand why GE's common stock touched six dollars during the last financial crisis as many of these asset classes became quite toxic.

One last startling piece of data is in reference to GECC's borrowing activities. We are all aware that GE Capital accepts bank deposits as a source of funding for its loans (and trading activity). However, you may not be aware that bank deposits ($45B) are only 8% of GECC's total assets. This means that the other 92% of their assets are funded by cash on hand or borrowings. GECC's total borrowings summed up to $386B at the end of the 9/30/12 quarter.

Valuation Discussion

What does all of this mean for the valuation? First, I think an investment in GE warrants an unusually high discount rate; I've settled on 12% to cover the risk that GECC will blow up again during the next financial crisis, whenever that occurs. GE's manufacturing business is strong and valuable but the inherent risk of the hedge fund attached to the manufacturing company is frightening when one considers a repeat of 2008 is likely in the future. In 2008, GE's earnings were wiped out completely despite a manufacturing and services business that was still profitable. The culprit was the garbage on GECC's balance sheet that sunk the whole ship. I believe this will happen again and investors need to be aware of the risk and compensated for it.

GE does pay a nice dividend on the common shares; it checked in at 3.6% at the time of this writing. This is roughly twice the yield on the U.S. 10-year Treasury and is also the only reason I can see taking a long position in this stock right now. The valuation has gotten way ahead of itself as investors have completely forgotten 2008 and have shown significant complacency with regard to GECC's risks.

Now we will take a look at a DCF approach to valuing GE common shares, and as a reminder, we are using a 12% discount rate to compensate for GECC's significant risks in an economic downturn. In addition, growth estimates, as well as 2012 and 2013 EPS are from analyst estimates compiled by Yahoo! Finance. I find the estimate of 11.3% growth for the next five years to be absolutely ludicrous, but we will go with that rate as it proves my bear thesis. Finally, the perpetual growth rate is set to 4% in this analysis (my number).

2012

2013

2014

2015

2016

2017

2018

Earnings Forecast

Reported earnings per share

$1.51

$1.68

$1.87

$2.08

$2.32

$2.58

x(1+Forecasted earnings growth)

11.30%

11.30%

11.30%

11.30%

11.30%

11.30%

=Forecasted earnings per share

$1.68

$1.87

$2.08

$2.32

$2.58

$2.87

Equity Book Value Forecasts

Equity book value at beginning of year

$11.69

$12.57

$13.60

$14.80

$16.20

$17.81

Earnings per share

$1.68

$1.87

$2.08

$2.32

$2.58

$2.87

-Dividends per share

$0.76

$0.80

$0.84

$0.88

$0.92

$0.97

$1.02

=Equity book value at end of year

$11.69

$12.57

$13.60

$14.80

$16.20

$17.81

$19.66

Abnormal earnings

Equity book value at begin of year

$11.69

$12.57

$13.60

$14.80

$16.20

$17.81

x Equity cost of capital

12.00%

12.00%

12.00%

12.00%

12.00%

12.00%

=Normal earnings

$1.40

$1.51

$1.63

$1.78

$1.94

$2.14

Forecasted EPS

$1.68

$1.87

$2.08

$2.32

$2.58

$2.87

-Normal earnings

$1.40

$1.51

$1.63

$1.78

$1.94

$2.14

=Abnormal earnings

$0.28

$0.36

$0.45

$0.54

$0.64

$0.73

Valuation

Future abnormal earnings

$0.28

$0.36

$0.45

$0.54

$0.64

$0.73

x discount factor (10%)

0.893

0.797

0.712

0.636

0.567

0.507

=Abnormal earnings disc to present

$0.25

$0.29

$0.32

$0.34

$0.36

$0.37

Abnormal earnings in year +6

$0.73

Assumed long-term growth rate

4.00%

Value of terminal year

$9.17

Estimated share price

Sum of discounted AE over horizon

$1.56

+PV of terminal year AE

$4.65

=PV of all AE

$6.21

+Current equity book value

$11.69

=Estimated current share price

$17.89

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As you can see, even with extremely sanguine growth estimates of 11.3% for five years, GE is currently only worth about $18 per share. As I said earlier, I believe these estimates are way too high based on the parent company's reliance on dividends from GE Capital. I think these estimates will come down over the next couple of years and GE shares will suffer as a result. Just in the past 90 days, estimates for 2013 have come down from $1.73 to $1.68. I believe this is foreshadowing more cuts in the future. GE has a great industrial business, but it is overpowered by the hedge fund that is referred to as GE Capital. GECC was responsible for enormous wealth destruction during the most recent financial crisis and will be again at some point in the future. I'm not here to debate when that will be, but it will happen again.

If I were a GE shareholder, these numbers would terrify me. I understand that GE has been around for 120 years and has consistently paid generous dividends (excluding the most recent financial crisis), but a look at their financial statements shows they are not the industrial giant they once were. Their industrial business is still huge and quite valuable but the 800 pound gorilla is the fixed income trading account known as General Electric Capital Corporation. During the next financial crisis, whenever it occurs, GE shareholders will be severely punished once again as the value of GECC nosedives with its toxic holdings. If you are a short-term holder of GE stock, you will probably survive since the odds of another 2008-style financial crisis hitting next year are low. I am simply suggesting GE has no place in a conservative investor's long-term portfolio.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.