A critical misconception behind GE’s latest stock plunge is that the industrial giant faces the same financial woes as Citigroup (C), Bank of America (BAC), and other major banks. Though the similarities are many, there are some startling differences.
A common misconception about GE Capital is that as other major banks, it may have as much as $45 billion in commercial mortgage backed securities (CMBS) that will need to be marked down, sharply decreasing the value of GE’s assets. However, our analysis shows that this is completely wrong. The latest 10-K shows that as of December 31, 2009, GE held as much as $50 billion in a commercial real estate loan book, a senior secured position where GE underwrites each individual property. This means that the $34 billion of equity is the actual value of the properties, with over 80% of that with no third party debt.
But how about CMBS? A close look to GE’s filing reveals that GE currently has only $2.9 billion of CMBS in its investment portfolio. This is a much lower figure than the rumored $50 billion floating around business channels and online forums. Figure 1 shows GE’s latest balance sheet.
So what are the risks associated with an investment in GE? In our view, several balance sheet adjustments must be made to answer this question. These adjustments must reflect GE’s value on a worst case basis. To that end, we have made the following adjustments to GE Capital’s balance sheet:
Currently, GE Capital accounts for its real estate holdings at the price they paid for them, depreciating the values over time, rather than periodically marking them to their current market values.
Adjustments: We have marked down GE Capital’s real estate asset holdings by 30% to reflect their possible current market value.
Currently, the balance sheet does not include the potential effects of a credit downgrade.
Adjustments: If the long-term credit rating of GE Capital were to fall below AA–/Aa3 or its short-term credit rating were to fall below A–1+/P–1 GE Capital would be required to provide approximately $3.5B of capital to various entities to account for this increase in credit risk.
Currently, the balance sheet does not include any potential losses due to deteriorating conditions in the market since December 31, 2008.
Adjustments: We have increased delinquency rates on on-book and off-book equipment financing loans and leases from 2.17% to 3.00%. Also, increased managed financing receivables delinquency rates, including defaulting consumer credit cards, from 7.47% to 10%.
Latest balance sheet excludes benefits in dividend cut announced February 27, 2009.
Adjustment: Dividend cut from 31 cents to 10 cents will allow GE to attain an extra $9B a year.
GE Capital holds $41B of investment securities, some of which are backed by consumer and commercial mortgages. Unrealized losses were included in fair value, but additional losses will mount if market continues to deteriorate.
Adjustments: We have marked down all investment securities at GE Capital by an additional 15% to reflect the possibility of further deterioration in asset-backed securities and continuing decline in property values. This adjustment resulted in an additional $7B write-down to the fair value calculations reported in the 2008 10-K.
GE Capital's worst case scenario adjusted balance sheet is shown in Figure 2.
Our analysis shows that in a worst case scenario basis, GE Capital is still valued at nearly $9B in equity, which is an 83% reduction in equity compared to that reported in the 2008 10-K. Writing down this equity in the consolidated balance sheet results in an adjusted equity of $71B for GE as a whole, or $6.51/share, as shown in Figure 3.
At its $7.41 close last week, GE was trading near our worst case scenario estimate of $6.41, making an investment at these price levels very low risk. Moreover, we believe that this worst case scenario is very unlikely to play out, which makes an investment in GE stock very attractive.
We believe that GE Capital’s method of accounting for its real estate holdings at the price they paid for them, depreciating the values over time, rather than periodically marking them to their current market values is the right approach for GE. This is because GE is a long-term investor, as unlike other financial institutions, it is not forced to sell any of these investments to raise additional cash. In the long-term, we expect the unrealized losses in mortgage-backed investment securities to shrink as the price of property values stabilizes.
It is important to note that we do not know what GE’s intrinsic value is. However, we do know that in a worst case scenario, GE is worth around $6.41/share. As this worst case scenario is unlikely to play out, GE’s current market price makes the stock a low risk investment with a high probability of further upside in the near term. In the long term, we believe an investment in GE stock will be very profitable once market fears about GE Capital assets start to dissipate.
Disclosure: We currently have a holding in GE.