GE's Dilemma: Sensible Business vs. Rating at Any Cost

Why Standard & Poor’s only lowered the outlook on General Electric (GE) bonds is anybody’s guess. By all traditional rating measurements, General Electric does not qualify as an “AAA” credit now and, in that respect, S&P provided misleading signals to equity investors. GE’s “stand-alone” bonds are, in any event, trading on the assumption that S&P has failed to fully incorporate the real prospects of a further deterioration in the global economic environment.

At an investor meeting on December 16, GE’s CEO Jeffrey Immelt emphasized that “the AAA is a philosophy of how you run the company.” Two days later, S&P announced that there is a 1-in-3 possibility of a rating downgrade for General Electric within two years. Will S&P just narrow that 2-year window if the recession worsens or will it be forced to bring down GE’s rating by at least two levels by mid-2009?

By all accounts, what General Electric needs to do today is to downsize its business model in order to preserve shareholder value, to limit the potential dilution for existing shareholders and to take serious steps to dramatically reduce the leverage content in its balance sheet. Rather than publicly maintaining the $5 billion earnings target (2009) for GE Capital, Mr. Immelt should be focusing on making adequate provisions for rising delinquencies in its $126 billion domestic and global consumer loan portfolio. Credit default swap spreads (at 425 basis points) are already reflecting the fact that, without support from its parent, GE Capital would or should be rated at least four notches lower. And that four-notch assessment might be too generous.

How much of the $15 billion that General Electric raised in recent months, including a $3 billion contribution from Warren Buffett, has gone to keep GE Capital alive? Are GE Capital’s forecasts for loan losses (900 million) too rosy, and are independent assessments in the $7 billion range more in tune with the times? Must GE Capital raise its tangible equity and solvency ratios in line with banking requirements before Mr. Immelt gives any further dividend and earnings guidance?

The parent, of course, has its own problems. Many of GE’s estimates for revenues from the sales of turbines worldwide are unrealistic, since none of those stimulus packages in countries like India and China are going to result in anything concrete, cash-wise, in the foreseeable future. If countless ongoing and proposed projects in the emerging markets (including the Middle East) are not downsized or postponed indefinitely, non-productive investment outflows will act as a further drain on liquidity.

Conceptually, it is difficult to imagine how a company which is essentially relying on tax-payer dollars to survive can sustain an “AAA” rating; but, then, these are strange times, and expected to get stranger in the months ahead. General Electric has issued $12.5 billion worth of bonds guaranteed by the Federal Deposit Insurance Corporation, as part of its plan to issue $45 billion of debt in 2009. Jeffrey Immelt plans to reduce GE’s reliance on the commercial paper market to $50 billion from the current level of $75 billion. The critical question is this: Will General Electric raise another $15 billion via equity before the third quarter of this year? If so, consider the evils of dilution at today’s prices.

Wall Street analysts are pointing out that GE’s “AAA” rating is extremely important, since an extra percentage point in interest would cost the company an extra $233 annually just on the domestic bonds issued ($23.3 billion) in the first half of 2008. For that matter, counterparties to the 8,000-plus GE Capital-referenced credit default swap contracts worth $74 billion (net notional value $11.5 billion) must be more concerned with a rating downgrade than Mr. Immelt himself.

In brief, like Washington lawmakers and regulators, all aboard the General Electric boat are obviously committed to the finger-in-the-dike strategy: keep the “AAA” rating going long enough, somehow, until changes in the economic climate solve the present dilemma. This writer’s view, however, remains, unchanged. Stay short General Electric, add to shorts in the face of the forthcoming Obama bounces, and wait to cover short positions below $10.

Disclosure: Author holds a short position in GE

Comments

[p4jain:]

Rakesh, I agree with shorting GE and staying short. But shorting GE with a dividend of 7% and holding shorts till mid 2009 means you are going to PAY significant dividend shorting GE. However, shorting SPY and ETF are good idea or buying SKF is better. No dividends. How do you deal with paying the dividends for the shorts you hold?

Jan 02 06:50 AM

[p4jain:]

Rakesh, I agree with shorting GE and staying short. But shorting GE with a dividend of 7% and holding shorts till mid 2009 means you are going to PAY significant dividend shorting GE. However, shorting SPY and ETF are good idea or buying SKF is better. No dividends. How do you deal with paying the dividends for the shorts you hold?

Jan 02 06:51 AM

[swygert@law...:]

I think p4jain makes a good point about shorting a high dividend flow, even should GE cut its dividend below 7%. Moreover, Mr. Saxena's argument about shorting the stock, of course is based on assumptions of a worsening global economy and he probably is right. But short sellers at the current levels of GE stock, in my opinion, taking a high risk. True, if the short selling is a judgement call on the company causing it to transform itself into a learner and more efficient comapny, that is the economic (vis-a-vis individual investor) benefit for shorts. In GE's case, it might cause management to transform the company in ways to make it more competitive.

However, speculators in shorts often get burned badly and shorting GE might be one of those situations. The good news is that Mr.Saxena is not advocating investors run to Treasuries and jump over a cliff.

By the way I have no troouble with Mr. Saxena being a short seller in GE and writing this article. It is very helpful for investors to know that those who write articles often are explaining their own investment moves.


On Jan 02 06:51 AM p4jain wrote:

> Rakesh, I agree with shorting GE and staying short. But shorting
> GE with a dividend of 7% and holding shorts till mid 2009 means you
> are going to PAY significant dividend shorting GE. However, shorting
> SPY and ETF are good idea or buying SKF is better. No dividends.
> How do you deal with paying the dividends for the shorts you hold?

Jan 02 10:35 AM

[helplessobs...:]

Sax,
Like most analysts you are late to the party. The smart money smelled trouble when GE, without reason, dropped from 42 to 32. That was the time for short sales, not now when the reason for the first drop is coming into view.

Jan 02 11:00 AM

[Rakesh Saxena:]

Thanks for your comment p4jain. The dividend factor has always to be factored in when shorting. In brief, what is the profit target after all costs and dues? But you have a point--the 7% factor is what, in my opinion, sustaining GE's stock price. - Rakesh


On Jan 02 06:50 AM p4jain wrote:

> Rakesh, I agree with shorting GE and staying short. But shorting
> GE with a dividend of 7% and holding shorts till mid 2009 means you
> are going to PAY significant dividend shorting GE. However, shorting
> SPY and ETF are good idea or buying SKF is better. No dividends.
> How do you deal with paying the dividends for the shorts you hold?

Jan 02 11:05 AM

[Rakesh Saxena:]

Dear helplessobserver: The 42-to-32 drop was under different market conditions. The shorts I am recommending are based solely on the facts as they present themselves today. FYI, I am not an "analyst"--I actually trade these shares and make derivative prices accordingly. Thanks for your comment. - Rakesh


On Jan 02 11:00 AM helplessobserver wrote:

> Sax,
> Like most analysts you are late to the party. The smart money smelled
> trouble when GE, without reason, dropped from 42 to 32. That was
> the time for short sales, not now when the reason for the first drop
> is coming into view.

Jan 02 11:09 AM

[Rakesh Saxena:]

Dear bocaj21: No, I am not recommending that investors jump over a cliff, not by any means. My forecast of a lower GE share price can be interpreted as a call for a leaner-and-meaner rationalization of GE's business model. Many thanks - Rakesh


On Jan 02 10:35 AM bocaj21 wrote:

> I think p4jain makes a good point about shorting a high dividend
> flow, even should GE cut its dividend below 7%. Moreover, Mr. Saxena's
> argument about shorting the stock, of course is based on assumptions
> of a worsening global economy and he probably is right. But short
> sellers at the current levels of GE stock, in my opinion, taking
> a high risk. True, if the short selling is a judgement call on the
> company causing it to transform itself into a learner and more efficient
> comapny, that is the economic (vis-a-vis individual investor) benefit
> for shorts. In GE's case, it might cause management to transform
> the company in ways to make it more competitive.
>
> However, speculators in shorts often get burned badly and shorting
> GE might be one of those situations. The good news is that Mr.Saxena
> is not advocating investors run to Treasuries and jump over a cliff.
>
>
> By the way I have no troouble with Mr. Saxena being a short seller
> in GE and writing this article. It is very helpful for investors
> to know that those who write articles often are explaining their
> own investment moves.

Jan 02 11:12 AM

[BerkeleyBob:]

I am not comfortable personally with short selling or trading in options. I was long GE for several years with periodic buys and sells. I recently sold because I was not reassured by the conference call, and although GE's other divisions have promise, GE Credit's books were opaque. Over the next year or two, it is potentially a liability rather than an asset. Having said that, I wish to add that short sellers have a place in the scheme of things and that a short sale is speculative, but a vote of no confidence in management or future growth in a manner that speaks more loudly than my bailing out on a few hundred shares. Who really is in control of GE? Who "owns" it?

Jan 02 01:08 PM

[Delojozafado:]

Those that go short may be forced to cover at some point. I know not where that is. In the meantime the market action since late Nov which seems less volatile and has developed a sustainable move on the S&P 500 to near or above the 50 day moving average seems to indicate a "bully-bear" market. It seems that Mr Obama's stimulus is going to look more like 1 trillion $s as it has already ballooned from an estimated $750 to $850 billion. We could see a classic Super Bowl indicator rally into the sell in May and go away phenomenon, which is about when the Autos and their suppliers will finally give up the ghost. With Indy& Pittsburg of the AFC being original NFL teams and both being in the playoffs, the odds of an original NFL(C) team winning the Super bowl are increased. I am for buying GE on the dips to $15.50 and below and placing a tight stop loss under it and tightening it up from $15.17 to 16.09 after the next ex div date in March. That ex div date is something to watch for as a sell signal as well if the price spikes in a continuing bull phase of a bear market. If there are significant disappointed shorts eager to cover before becoming liable for the dividend...

Jan 03 09:25 AM

[discov:]

I am looking for GE to be in the single digits sometime before summer. I bought the June 13 puts. That way, I don't have to worry about the dividend going against me, plus I only risk what I pay for them (unlike shorting the common)

concisetrading.blogspo.../
Ryan

Jan 03 09:04 PM